391
WHAT’S NEW IN THE SEVENTH EDITION:
A new
Case Study
on
Left-Digit Bias
has been added and a new
In the News
feature on “Can Brain
Science Improve Economics?” has been added.
LEARNING OBJECTIVES:
how to examine problems caused by asymmetric information.
the market solutions to asymmetric information.
why people may not always behave as rational maximizers.
CONTEXT AND PURPOSE:
research. The first topic addressed is
asymmetric information
, a situation when one person in an
economic relationship has more relevant knowledge than the other person does. The second topic is
government. The third topic addressed is
behavioral economics
, the introduction of psychology into the
study of economic issues.
KEY POINTS:
22
FRONTIERS OF
MICROECONOMICS
392 ❖ Chapter 22/Frontiers of Microeconomics
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
characteristics, buyers may be concerned about the problem of adverse selection among the sellers.
Private markets sometimes deal with asymmetric information with signaling and screening.
 Although government policy can sometimes improve market outcomes, governments are themselves
imperfect institutions. The Condorcet paradox shows that the majority rule fails to produce transitive
preferences for society, and Arrow‘s impossibility theorem shows that no voting system will be
perfect. In many situations, democratic institutions will produce the outcome desired by the median
 The study of psychology and economics reveals that human decision making is more complex than is
assumed in conventional economic theory. People are not always rational, they care about the
fairness of economic outcomes (even to their own detriment), and they can be inconsistent over
time.
CHAPTER OUTLINE:
I. Asymmetric Information
B. Examples
1. A worker knows more than his employer about the level of his work effort. This is an
example of a
hidden action
.
2. A seller of a used car knows more than the buyer does about the car‘s condition. This is an
example of a
hidden characteristic
.
C. When there is asymmetric information, the party without the relevant knowledge would like to
have such knowledge, but the other party may have an incentive to conceal it.
D. Hidden Actions: Principals, Agents, and Moral Hazard
1. Important Definitions
b. Definition of agent: a person who is performing an act for another person,
called the principal.
performing some act.
This is a great chapter to get students interested in further study of economics. It is
important for the students to learn that economics is a growing and developing
science and that economists are always looking for new areas to study and new
phenomena to explain.
Chapter 22/Frontiers of Microeconomics ❖ 393
2. The employment relationship is the classic example.
b. Employers can respond by providing better monitoring, paying higher wages, or delaying
3.
FYI: Corporate Management
b. This creates a principal–agent problem where the shareholders are the principals and the
managers are the agents.
d. As a result, many managers are provided compensation packages that provide incentives
to act in the best interest of corporate profits.
1. Definition of adverse selection: the tendency for the mix of unobserved attributes
3. When markets suffer from adverse selection, the invisible hand does not necessarily work
well.
b. In the labor market, wages may be stuck at a level above the equilibrium wage, resulting
in unemployment.
the price is too high.
F. Signaling to Convey Private Information
1. Definition of signaling: an action taken by an informed party to reveal private
information to an uninformed party.
2. Examples of Signaling
b. Students may spend time in school to signal that they are high-ability individuals.
3. For a signal to be effective, it must be costly. However, it must be less costly (or more
394 ❖ Chapter 22/Frontiers of Microeconomics
4.
Case Study: Gifts as Signals
a. Because people know their own preferences better than anyone else, we would expect
that they would prefer cash gifts.
b. However, the ability to choose the right gift for someone may serve as a signal of an
individual’s love.
c. Note that choosing the right gift is costly and the cost depends on how well the giver
knows the recipient (which may be determined as a measure of the giver’s level of
interest in the recipient).
G. Screening to Uncover Private Information
1. Definition of screening: an action taken by an uninformed party to induce an
informed party to reveal information.
2. Examples of Screening
purchase.
b. An insurance company may offer different policies that would lead safe or risky drivers to
reveal themselves. Safe drivers are likely to prefer policies with low premiums and high
deductibles. Risky drivers are more likely to prefer policies with higher premiums and low
deductibles.
H. Asymmetric Information and Public Policy
2. Asymmetric information is another reason why market outcomes may be inefficient.
3. However, three factors make it difficult for the government to improve the outcome in some
cases.
combination of signaling and screening.
b. The government rarely has more information than the private parties do.
c. The government is itself an imperfect institution.
Chapter 22/Frontiers of Microeconomics ❖ 395
Activity 1—A Market for Lemons
Type: In-class demonstration
Topics: Asymmetric information, signaling, regulation
Materials needed: Prepared instruction sheets and record sheets
Time: 50–60 minutes
Class limitations: Works in any size class, although using a larger number of groups
will result in a larger amount of time necessary to complete each
round
Purpose
This classroom experiment demonstrates how a market for lemons can develop when buyers
have no information on the quality of a product available for sale.
Instructions
Divide the class into seven groups, three sellers and four buyers. Try to keep the groups
the first few rounds of the game:
1. Sellers must decide their product quality and price simultaneously. Each seller can
choose only one product quality but can sell up to two units each period. Sellers’
decisions are recorded and given to the instructor.
2. Once all of the sellers have made their decisions, the instructor lists the sellers’
product quality and the price on the board.
choices.
4. Profit for sellers will be the difference between the price and the cost (given to them
on their instruction sheets) for each unit sold. Due to rising marginal cost, the cost of
the second unit is $1.00 more than the first. The cost information for each firm is:
consumer (given on their instruction sheets) and the price paid. The value for each
buyer is:
Quality 1 Quality 2 Quality 3
Value to the buyer $5.00 $9.80 $14.50
6. Once a few rounds have been played, the instructor should announce that he will only
list the sellers’ prices on the board. Buyers must base their decisions entirely on price
information.
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II. Political Economy
1. Most advanced societies rely on democratic principles, allowing the majority to set
government policy.
2. For most policy issues, the number of possible outcomes exceeds two.
3. Example: Three possible outcomes (A, B, and C) and three voter types (Type 1, Type 2, and
Type 3). The mayor of a town wishes to aggregate the individual preferences into
preferences for society as a whole.
Points for Discussion
Begin by discussing the results of the rounds where buyers and sellers had complete
information.
1. Do sellers or buyers benefit from a higher quality of product?
2. What is the most efficient quality? (Which maximizes total surplus?)
3. Suppose the market ended up with only Quality 2 products? Would it be efficient for a
regulator to force firms to manufacture Quality 3 products? Why or why not?
Students will generally figure out that Quality 2 maximizes the sum of producer and con
surplus in the market. To illustrate this point, the instructor can graph the supply and de
curves for each quality.
Once you have discussed the market with full information, start a discussion on the resu
the information asymmetry.
1. What happened in the market when buyers were unable to distinguish the product
quality?
2. Why were firms driven to produce the lowest quality?
3. In reality, is there any way for a firm to reveal the quality of its product?
Most students will reply that the producers were able to take advantage of buyers in this
situation and thus cut product quality. Buyers quickly learned to protect themselves and on
purchased lower priced goods. This led to a market where the only good available for sa
of the lowest quality.
Students may discuss the ability of a firm to signal its quality through expensive
advertisements or product guarantees and warranties.
Chapter 22/Frontiers of Microeconomics ❖ 397
Type 1
Type 2
Type 3
Percent of Electorate
35
45
20
First Choice
A
B
C
Second Choice
B
C
A
Third Choice
C
A
B
b. This violates transitivity. We generally expect that if A is preferred to B and B is preferred
to C, then A would be preferred to C.
c. Definition of Condorcet paradox: the failure of majority rule to produce
transitive preferences for society.
C. Arrow’s Impossibility Theorem
1. In a 1951 book, economist Kenneth Arrow examined if a perfect voting system exists.
a. Unanimity.
b. Transitivity.
c. Independence of irrelevant alternatives.
d. No dictators.
4. Definition of Arrow impossibility theorem: a mathematical result showing that,
under certain assumed conditions, there is no scheme for aggregating individual
preferences into a valid set of social preferences.
for social choice.
Table 1