Econ 11


Mankiw, Chapter 22: Frontiers of Microeconomics

Asymmetric Information or information asymmetry: one party knows more than another.

The principal-agent situation.

Principal hires an agent to do a job.

In government, the voters are the principals and the elected representatives the agents.

In employment, the employer is the principal, and the worker is the agent.

The problem: the agent has his own goals, which may conflict with those of a principal.

A lawyer as agent wants high fees and could exploit the principal who hires him.

Why the problem: asymmetric information.

The agent has more knowledge than the principal.

In employment, the worker may wish to avoid working hard.

He may shirk his work responsibilities, wasting time the employer is paying for.

Remedy: monitoring, paying an efficiency wage, paying a bonus for good work.

In insurance, there are two principal-agent problems.

1. Moral hazard. The tendency of an insured person to engage in more risk or use more of the provided service than he is expected to.

For example, if the government provides disaster relief, this induced more people to live in places that get flooded or have fire dangers.

There is an excess burden on society for such insurance to be subsidized.

In the world's economy, there is moral hazard when the IMF bails out countries with debts.

2. Adverse selection. Those who are more costly are the ones who have more insurance.

Sick people are more likely to get medical insurance than healthy people.

People with bad used cars are more likely to sell them.

Remedy: screening and insurance. Get the car checked, and get a warranty.

Response to information asymmetry: signaling: acts which reveal private information.

Advertising: big spending on ads for good products signals quality, since otherwise the cost is wasted. University degrees act as a signal of human capital.

An effective signal must be costly.

An appropriate gift is a signal of love and affection.

Market responses to asymmetric information are not perfect, but

governmental remedies may be worse.

Public choice economics: the application of economic theory to politics and government.

Premise: human nature does not change when people enter into government.

Self-interest still exists.

The Condorcet voting paradox.

Voting on more than 2 issues is not transitive (p. 485).

The order in which the vote is taken can matter.

So those who set the agenda have political power.

Arrow's impossibility theorem. Desirable properties of a voting system:

1) unanimity

2) transitivity

3) independence of irrelevant alternatives

4) no dictatorship

The theorem: no voting system can satisfy all these properties together.

There is no general will or will of the people.

However, demand revelation overcomes this for public goods.

And some voting methods for candidates are better than others.

Voting by ranking is better than simple majority voting.

The median voter: for a single issue, a linear position possibility.

The position where half want more and half want less is the median.

The median voter theorem: majority rule will produce the outcome preferred by the median voter.

That is why with two major political parties, candidates tend to move towards the center.

Minority views are not given much weight.

The voting structure is mass democracy, many people voting for candidates they don't know.

Candidates need funds to finance mass media campaigns.

This demand leads to a supply by special interests.

They contribute funds and get favor in return:

subsidies that are paid for by taxpayers and consumers.

Politicians trade vote to pass their legislation.

Behavioral economics: the application of psychology to economics.

Economics presume rational behavior.

But some economists claim that people are not always rational.

Investors, for example, are overconfident and don't like to admit to losses.

But this does not really contradict rationality.

It is a preference for things other than monetary gain.

They are still maximizing utility. This includes avoiding work even if it results in a money gain.

The ultimatum game: $100, A offers B $99. B rejects it.

Is B irrational? No. Fairness is part of his utility.

Rationality does not mean that all people care about is money.

People maximize utility, and utility is subjective.

Preferences change over time, and time preference is not linear.

In the evening you set the alarm for 6 AM, but in the morning, you turn off the alarm and go back to sleep. Irrational? No, your preferences have changed.

The rationality of an act is based on the preferences at the moment of choice.

To overcome changes in preferences, one should try to commit oneself or make it more costly to change the choice, such as having several alarm clocks far from the bed.

Do #6, p. 495, Problems and Applications.