ASYMMETRIC INFORMATION

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1 Mariusz Próchniak Chair of Economics II Warsaw School of Economics ASYMMETRIC INFORMATION Managerial Economics 1 Asymmetric information In situations characterised by asymmetric information, one party knows more than another about key economic facts. The presence of asymmetric information can lead to two important effects: adverse selection, moral hazard. 2

2 Adverse selection The firm has introduced a medical program for its employees and their spouses that will pay for maternity-related related health expenses. Employees who elect this coverage pay an additional premium. The firm estimates that 1 in 20 of its employees will have a new baby in a given year (this estimate comes from records for the last 10 years). The company has set the premium to cover its expected payouts at this 1-in1 in-20 rate. 3 Adverse selection In the first two years of the program, the company has lost an enormous amount of money on the program. Employees covered by the plan are having babies at the rate of 1 in 10 per year. Is this bad luck or bad planning? 4

3 Adverse selection The company s losses are not due to bad luck. The firm s losses are due to adverse selection. The following table lists the hypothetical numbers for the first year of the program: Baby No Baby Total Policy No policy Total Adverse selection Couples who are planning to have children will tend to elect the policy; those who are not will forgo the coverage. This behaviour usually is termed self selection. From the company s point of view, the result is called adverse selection: : couples who are most likely to have babies (and know this) will most likely elect the coverage. 6

4 Adverse selection In general, adverse selection occurs because of asymmetric information. Individuals have better information about their true risks than the insurance provider does. As a result, individuals at the greatest risk elect insurance coverage. To avoid losses on their policies, insurance companies must anticipate this behaviour and set their premiums accordingly. 7 The principal-agent agent problem and moral hazard The principal-agent agent problem The actions of one party (the one with better information) affect the welfare of a second party. The party who takes the action is the agent. The affected party who has only limited information about and control over the agent is the principal. 8

5 The principal-agent agent problem and moral hazard The principal-agent agent problem examples A physician (agent),, who has superior knowledge, takes actions that affect the welfare of his or her patient (principal). A supplier (agent) may or may not live up to his or her contractual obligations to serve a buyer (principal). Within the firm, employees (agents) may not have the incentives to act according to their employer s (principal s) wishes. And although the law requires that management act in the best interests of stockholders, the stockholders typically lack the information to know whether management is indeed making decisions in the stockholders interest. 9 The principal-agent agent problem and moral hazard Moral hazard The problem of moral hazard occurs when an agent has incentives to act in its own interests, contrary to the interests of the principal. 10

6 Adverse selection and moral hazard Adverse selection occurs when the agent (whose interests are at odds with the principal s) holds unobservable or hidden information. Moral hazard occurs when an agent (whose interests are at odds with the principal s) takes unobservable or hidden actions. 11 Adverse selection and moral hazard Examples A life insurance policy may attract those with serious health problems (adverse selection) and may cause those covered to begin to engage in more risky behaviour (moral hazard). An employment contract may attract lower-productivity employees (adverse selection) and give those workers incentives to engage in self-serving serving actions at the expense of the employer (moral hazard). 12

7 Thank you very much for the attention!!! 13