Chapter 10 – Information
CHAPTER 10
INFORMATION
Chapter Overview
People make decisions based on what they know, but sometimes they don’t
have enough information to make good decisions. One of the key
assumptions behind perfect markets is that individuals have perfect
information. When this is not true, individuals are not necessarily able to
make decisions that set marginal benefits equal to marginal costs.
We’ve seen in this chapter that in many situations information asymmetry
can allow one person to take advantage of another. In other cases, markets
may fall apart because people are afraid to trade with one another. Problems
like adverse selection and moral hazard can derail what appear to be clever
programs or business models.
Screening and signaling, if used correctly, can help to correct these
ine$ciencies and increase surplus. Statistical discrimination can also be
helpful, but it can have unintended downsides. Sometimes government may
step in to correct information problems that affect large numbers of people.
The success of government regulation, however, depends on whether or not
people understand and are motivated to use the information made available
to them.
Learning Objectives
LO 10.1: Explain why information asymmetry matters for economic decision
making.
LO 10.2: Explain how adverse selection is caused by asymmetric
information.
LO 10.3: Explain how moral hazard is caused by asymmetric information.
LO 10.4: differentiate between screening and signaling and describe some
applications of each.
LO 10.5: Explain how reputations can help to solve information problems.
LO 10.6: Explain how statistical discrimination might be used to solve
information problems.
LO 10.7: Discuss the uses and limitations of education and regulation in
overcoming information asymmetry problems.
Chapter Outline
OPENING STORY: A SOLUTION FOR STUDENT LOANS?
Information: Knowledge Is Power
10-1
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Chapter 10 – Information
Information Asymmetry (LO 10.1)
Adverse Selection and the Lemons Problem (LO 10.2)
Principal–Agent Problems and Moral Hazard (LO 10.3)
BOX FEATURE: REAL LIFE – THE WEATHER CAN’T CHEAT
Moral Hazard and Adverse Selection—Avoiding Confusion
Solving Information Problems
Screening (LO 10.4)
BOX FEATURE: WHERE CAN IT TAKE YOU? – RISK MANAGEMENT
Signaling
BOX FEATURE: REAL LIFE – DRESS FOR SUCCESS
Reputation (LO 10.5)
Statistical Discrimination (LO 10.6)
BOX FEATURE: WHAT DO YOU THINK? – FROM SPRAY PAINT TO AUTO
INSURANCE
Regulation and Education (LO 10.7)
BOX FEATURE: REAL LIFE – GOT ADVERSE SELECTION? BRANDING AND
REGULATING MILK
BOX FEATURE: WHAT DO YOU THINK? – HOW MUCH INFORMATION IS TOO
MUCH?
Beyond the Lecture
Class Discussion: Information Asymmetry (LO 10.1)
In order to highlight the importance of information asymmetry, consider
discussing Chapter 2 of Freakonomics. The chapter provides an overview of
how prior to the internet real estate agents were able to control information
about the housing market, in particular comparable sales. You can also show
students this brief video by the authors of Freakonomics that discusses the
chapter and explains the incentives of real estate agents.
1. What information do real estate agents have that buyers and sellers
may not have, especially prior to the internet?
2. Prior to the internet, how could some real estate agents possibly use
information asymmetry, along with the control of information, to their
advantage?
Class Discussion: Information Asymmetry and Reputation (LO 10.1,
LO 10.5)
Consider showing and discussing this brief clip from the TV show Seinfeld.
1. Why is there asymmetric information between automobile mechanics
and the owners of the cars?
2. What is the potential impact of asymmetric information on the owner
of the car?
3. How can reputation help to mitigate asymmetric information?
Class Discussion: Adverse Selection (LO 10.2, LO 10.3)
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Chapter 10 – Information
Link to this March 2016 Hu$ngton Post Article detailing some issues with
Obamacare. Specifically, the article discusses rising costs of the program.
(Note that the Hu$ngton Post had other articles which laid out bad news for
Obamacare, which is slightly unusual since it is a very left-wing publication).
1. Why didn’t the “old and sick” people have health insurance before
Obamacare?
2. Why are the “old and sick” enrollees causing insurance costs to go up?
3. How were costs expected to be kept low? What hasn’t happened yet in
terms of types of people enrolling in the program?
Class Media: Reputation (LO 10.5)
Use two clips from the movie American Gangster (51:44–54:03 and 1:31:56–
1:34:17) to highlight the possibility of using branding and reputation to
convey information to consumers. In the clips, Denzel Washington’s
character actually brands the higher quality drugs that he sells. Watch 51:44-
54:03 and1:31:56-1:34:17.
Clicker Questions
There are three main purposes to clicker questions. First, they are a great
way to do a quick and instant “on demand” test of student understanding of
the material. You can cover material, and instantly get feedback on student
comprehension. You can see whether you need to explain certain topics
again, or move on to the next subject. Second, they are a great method to
break up the class and take a moment away from lecture. It gets the
students actively involved. Finally, certain clicker questions can be framed in
a “discussion” manner, in which you can invite students to talk about the
possible right answer with their peers. You can instruct students to convince
their classmate of a right or wrong answer.
1. What is a possible result of information asymmetry? [LO 10.1]
A. Individuals will be irrational
Feedback: Asymmetry can be harmful to the person with less information
in the transaction. However, this undesired result generally only happens if
incentives are not aligned.
2. Jim is selling his house, but only shows potential buyers the best rooms in
the house and doesn’t show them the downstairs bathroom which has
broken cabinets and no plumbing. This is an example of… [LO 10.2]
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Chapter 10 – Information
D. Both parties having perfect information
3. Mike got a new employer which pays his entire cell phone bill every
month. Since then, Mike has started using more data and making more non-
work-related calls with his phone. This is an example of which of the
following? [LO 10.3]
A. Adverse selection
Feedback: He’s using the benefits of his phone while passing the costs on
to others. While this doesn’t involve “risks”, he is doing more of the behavior
since someone else is absorbing the costs.
4. Services such as Yelp, Angie’s List allow consumers to read and write
reviews of service providers. The goal of these services is to… [LO 10.1,
10.2]
A. Lower the prices of the services provided
Feedback: In general, the services aim to provide information to consumers
so they are more fully informed of the price, quality, and reliability of certain
contractors or other services.
5. Mark is the owner of a grocery store. He hires Todd to be the day-to-day
manager of operations. Mark and Todd have di%erent ideas of how the
business should operate. This is an example of… [LO 10.3]
A. Adverse selection
Feedback: Separation of ownership and management of a business is often
subject to the principal-agent problem.
Solutions to End-of-Chapter Questions and Problems
Review Questions
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Education.
Chapter 10 – Information
1. Return to the description of the student loan program that opened the
chapter. Suppose that all students at the university are perfectly altruistic
and share the university’s goal of reducing debt for graduates with low
incomes. Would information asymmetry cause a problem in this situation?
Why or why not? [LO 10.1]
Answer: If students shared the university’s goal of reducing debt for
graduates with low incomes, information asymmetry would not be a
problem. Asymmetric information is a problem only when the two sides of
2. Suppose you are in the market to purchase your first home. You found a
house you like in your price range and are buying directly from the previous
owner. Describe an information asymmetry in this situation. Explain who is
likely to benefit from this information imbalance. [LO 10.1]
Answer: The previous owner of the home will have more information than
you will have about any issues with the house, such as problems with the
3. A club charges a Oat fee for an open bar (all-you-can-drink). Describe the
adverse-selection problem. [LO 10.2]
Answer: A Oat fee for an open bar is appealing to people who intend to
drink a lot. A person who wants only one or two drinks will not benefit
4. A course description posted during the registration period notes that
homework is graded complete or incomplete rather than being corrected by
the instructor. Describe the adverse-selection problem. [LO 10.2]
Answer: A course advertising that homework will receive credit if it is
complete, regardless of whether it is actually correct, will
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Chapter 10 – Information
5. A club charges a Oat fee for an open bar (all-you-can-drink). Describe the
moral-hazard problem. [LO 10.3]
Answer: Once you have paid a Oat fee for an open bar, you may be
tempted to drink more than you would have if you were paying by the
6. Imagine that you own a bagel shop, which you visit once a day. According
to company policy, employees are supposed to pay for all the bagels they
eat. Why is moral hazard likely to be a problem in this situation, and what
could you do to prevent it? [LO 10.3]
Answer: Moral hazard is likely to be a problem because there is very little
monitoring if the owner stops by only once a day. Employees have an
7. The college admissions process involves both screening and signaling.
Give an example of each. Who is doing the screening? Who is doing the
signaling? [LO 10.4]
Answer: An example of screening would be the admissions committee
checking high school grades and test scores for minimum standards. An
example of signaling would be an applicant highlighting her participation
8. Explain why joining a fraternity or sorority might include elaborate or
difficult rituals. [LO 10.4]
10-6
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Chapter 10 – Information
Answer: A person’s willingness to participate in elaborate or difficult
9. Walter wants to signal his devotion to Emily. He has $75 and is
considering a bracelet for Emily or a tattoo for himself of her name. Which is
the more effective signal? [LO 10.4]
Answer: The tattoo is a more effective signal of devotion. The most
10. Advertising often features testimonials from satisfied customers, who
happily describe the characteristics of the goods or services they received.
Why do advertisers use this technique rather than a direct description of the
goods or services? [LO 10.5]
Answer: People assume that the opinions of other customers are more
reliable than what the seller would say about the product himself. If we
11. Two instructors are offering elective courses this semester. One
instructor has been teaching at the university for several years. The other
instructor is new. For which instructor will teaching evaluations be the most
important this semester? Explain why. [LO 10.5]
Answer: Think about how you sign up for elective classes. Do you ever
ask your peers, “What’s the instructor like?” The reputation of the
professor is an important and valid consideration when you have a choice
12. Consider the market for life insurance. Give an example of statistical
discrimination an insurer might use to set premiums. [LO 10.6]
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Chapter 10 – Information
13. Consider the market for auto insurance. Explain why insurers ask
student drivers about their grades. [LO 10.6]
Answer: Insurers ask about grades because being a good student is
14. Suppose the government is thinking of requiring pharmaceutical
companies to print the exact chemical formulas of medications on the label,
so consumers will know exactly what they are ingesting. Is the new
disclosure rule likely to benefit the average consumer? Explain your
reasoning. [LO 10.7]
Answer: The new disclosure rule would not be likely to benefit the
average consumer. Consumers do need information that helps them
15. Some people have argued that mandatory health insurance could
reduce health-care costs. Explain this argument. What problem would
mandatory coverage not solve that could undermine cost savings? [LO
10.7]
Answer: Mandatory insurance would address the problem of adverse
selection. By preventing people from opting out, the pool of people paying
premiums will increase. Part of the assumption people are making with
Problems and Applications
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Chapter 10 – Information
1. In which of the following situations is an information asymmetry likely to
cause problems? [LO 10.1]
a. Cab drivers know the shortest route to any destination better than their
passengers do.
b. Managers can’t always supervise members of their sales sta% who work
on commission. (That is, sta% members receive a percentage of the total
value of the sales they make.)
Answer: a. Cab drivers know the shortest route to any destination better
2. In which of the following situations is an information asymmetry likely to
cause problems? [LO 10.1]
a. Parents know more than their children about how to write a good college
application.
b. People who book hotel rooms online know less about the quality of the
room they are reserving than the hotel’s management.
Answer: b. People who book hotel rooms online know less about the
quality of the room they are reserving than the hotel’s management. For
3. Which of the following situations are likely to involve adverse selection?
[LO 10.2]
a. After receiving an emergency call during class, a professor leaves
students unsupervised for the rest of the period.
b. A course has a reputation for being an easy A, even though after the term
begins, students realize that it isn’t.
c. A course is a requirement for physics majors but an elective for biology
majors.
Answer: b. A course has a reputation for being an easy A, even though
after the term begins, students realize that it isn’t. Adverse selection is a
10-9
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Education.
Chapter 10 – Information
4. In which of the following situations is adverse selection not a concern?
[LO 10.2]
a. A company offer employees the opportunity to purchase group health
insurance.
b. A company requires employees to purchase group health insurance.
c. The health insurance plan does not include dental care.
Answer: b. A company requires employees to purchase group health
5. There is a town with exactly 1,000 residents. 75% of the residents make
healthy choices, and 25% of the residents consistently make unhealthy
choices, but the health insurance company in town cannot tell who is healthy
and who is unhealthy. A healthy person has an average of $600 in medical
expenses each year and is willing to pay $800 for insurance. An unhealthy
person has an average of $1,600 in medical expenses each year and is
willing to pay $2,000 for insurance. The health insurance provider can o%er
insurance at only one price. [LO 10.2]
a. In equilibrium, what is the minimum price of insurance?
b. In equilibrium, who will buy insurance?
Answer: The health insurance provider can o%er only one price. If it tries
to cover the costs of both the unhealthy and the healthy individuals, its
6. Which of the following situations are likely to involve moral hazard? [LO
10.3]
a. After receiving an emergency call during class, a professor leaves
students unsupervised for the rest of the period.
b. A course has a reputation for being an easy A, even though after the term
begins, students realize that it isn’t.
c. A course is a requirement for physics majors but an elective for biology
majors.
Answer: a. After receiving an emergency call during class, a professor
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Chapter 10 – Information
7. In which of the following government policies is moral hazard not a
concern? [LO 10.3]
a. Government provides disaster relief for homeowners who lose their homes
in a Oood.
b. Government provides unemployment insurance when workers are laid o%.
c. Government raises taxes to pay for social services.
d. Government requires hospitals to treat anyone who comes to the
emergency room, regardless of insurance status.
Answer: c. Government raises taxes to pay for social services. With
8. Say whether each of the following situations involves screening or
signaling. [LO 10.4]
a. Auto shops and motels advertise that they are AAA-approved.
b. Employers check interviewees’ Facebook or MySpace profiles before hiring
one of them.
c. Applicants must pass an exam before becoming eligible for a civil service
position.
d. People wear expensive clothing with large brand names or logos.
Answer: When people take action to reveal their own private information,
they are signaling. Screening involves taking action to make someone
reveal private information.
a. Signaling. Auto shops and motels advertise that they are AAA-
approved.
9. Jane uses an online dating service. For each of the following activities, say
whether Jane is screening or signaling. [LO 10.4]
a. Jane views profiles of only nonsmokers.
b. Jane describes her volunteer activities in her profile.
c. Jane lists museums and foreign films among her interests.
d. Jane looks for matches who live within 25 miles of her address.
Answer: When people take action to reveal their own private information,
a. Screening. Jane views profiles of only non-smokers.
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Chapter 10 – Information
10. Consider the effect of reputation and say whether you are likely to be
treated better in scenario a or scenario b. [LO 10.5]
a. You tell an auto mechanic that you have just moved to town.
b. You tell an auto mechanic that you are moving out of town.
Answer: a. You tell an auto mechanic that you have just moved to town.
11. Consider the effect of reputation and say whether you are likely to be
treated better in scenario a or scenario b. [LO 10.5]
a. You are purchasing your car from an individual who advertised it on
craigslist.
b. You are purchasing your car from a local dealership.
Answer: b. You are purchasing your car from a local dealership.
12. In college admissions, which of the following are examples of statistical
discrimination? Choose all that apply. [LO 10.6]
a. A college has minimum required scores on standardized tests.
b. A college is an all-women’s school.
c. A college uses high-school GPA to rank students for scholarship offer.
d. A college requires three letters of recommendation.
Answer: a and c. Statistical discrimination is the process of distinguishing
13. In a market for car insurance, which of the following are examples of
statistical discrimination? Choose all that apply. [LO 10.6]
a. Premiums are adjusted based on the zip code of the insured.
b. Premiums are adjusted based on the color of the car.
c. Premiums are adjusted based on the driving record of the insured.
d. Premiums are adjusted based on the model of the car.
Answer: All are examples of statistical discrimination. Statistical
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Chapter 10 – Information
generalizing based on observable characteristics in order to fill in missing
information.
14. Say which public regulation approach is likely to be more effective in
providing information to consumers of pharmaceuticals. [LO 10.7]
a. Requiring pharmaceutical companies to list major side effects of their
medications in television advertisements.
b. Requiring pharmaceutical companies to post online the full text of
research results from medical testing done during the development of new
drugs.
Answer: a. Requiring pharmaceutical companies to list major side e&ects
of their medications in television advertisements. When an information
15. Say which public regulation approach is likely to be more effective in
providing information to consumers of restaurant meals. [LO 10.7]
a. Filing a notice at city hall when a restaurant fails a health and sanitation
inspection.
b. Posting a public notice on the door of a restaurant that fails a health and
sanitation inspection.
Answer: b. Posting a public notice on the door of a restaurant that fails a
health and sanitation inspection. When an information problem is
pervasive and has a pronounced negative effect on society, government
10-13
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