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371
WHAT’S NEW IN THE EIGHTH EDITION:
There is a new
In the News
feature on "Using Deviations from Rationality" and a new question has been
added to the Problems and Applications section.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ how to examine problems caused by asymmetric information.
➢ the market solutions to asymmetric information.
➢ why democratic voting systems may not represent the preferences of society.
➢ why people may not always behave as rational maximizers.
CONTEXT AND PURPOSE:
Chapter 22 is the last chapter in the microeconomics portion of the text. It is the second of two unrelated
chapters that introduce students to advanced topics in microeconomics. These two chapters are intended
to whet their appetites for further study in economics.
KEY POINTS:
• In many economic transactions, information is asymmetric. When there are hidden actions, principals
may be concerned that agents suffer from the problem of moral hazard. When there are hidden
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
22
FRONTIERS OF
MICROECONOMICS
372 ❖ Chapter 22/Frontiers of Microeconomics
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
voter, regardless of the preferences of the rest of the electorate. Moreover, the individuals who set
government policy may be motivated by self-interest rather than national interest.
CHAPTER OUTLINE:
I. Asymmetric Information
A. Many times in life, one person holds more knowledge about what is going on than another. Such
a difference in access to relevant information is known as an
information asymmetry
.
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
.
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
a. Definition of moral hazard: the tendency of a person who is imperfectly
monitored to engage in dishonest or otherwise undesirable behavior.
2. The employment relationship is the classic example.
a. Workers (agents) may be tempted to shirk their work-related responsibilities because
their employers (the principals) do not monitor their behavior closely.
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 ❖ 373
b. Employers can respond by providing better monitoring, paying higher wages, or delaying
part of the worker's pay until later in the worker's life.
3.
FYI: Corporate Management
a. From an economic standpoint, the most important feature of the corporate form of
organization is the separation of ownership and control.
E. Hidden Characteristics: Adverse Selection and the Lemons Problem
1. Definition of adverse selection: the tendency for the mix of unobserved attributes
to become undesirable from the standpoint of an uninformed party.
2. Examples include the used car market, the labor market, and the market for insurance.
3. When markets suffer from adverse selection, the invisible hand does not necessarily work
well.
a. In the used car market, owners of "cherry" or "plum" cars may choose to keep them
rather than sell them at a low price.
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
a. Firms may spend money on advertising to signal the high quality of their products.
b. Students may spend time in school to signal that they are high-ability individuals.
374 ❖ Chapter 22/Frontiers of Microeconomics
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
a. A buyer of a used car may ask to have the car examined by a mechanic prior to
purchase.
H. Asymmetric Information and Public Policy
1. Market failures such as externalities, public goods, imperfect competition, and poverty show
that governments can sometimes improve market outcomes.
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.
a. The private market can sometimes deal with information asymmetries on its own using a
combination of signaling and screening.
Chapter 22/Frontiers of Microeconomics ❖ 375
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
separated and make sure that students know not to reveal their cost or value information to
anyone. Pass out instruction sheets and record sheets for each group. Here are the rules for
the first few rounds of the game:
1. Sellers must decide their product quality and price simultaneously. Each seller can
3. The instructor draws a number from a hat (1 through 4) and this will be the first
buyer to make a purchase. Buyers decide which firm to buy from based on preferred
quality and price. Buyers may purchase only one unit each period. Once a seller has
sold two units, he or she can sell no more and should be eliminated from the list of
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:
Quality 1 Quality 2 Quality 3
Cost of 1st unit $1.75 $4.95 $11.35
Cost of 2nd unit $2.75 $5.95 $12.35
5. For the buyers, consumer surplus will be the difference between the value to the
consumer (given on their instruction sheets) and the price paid. The value for each
buyer is:
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.
376 ❖ Chapter 22/Frontiers of Microeconomics
II. Political Economy
A. Definition of political economy: the study of government using the analytic methods of
economics.
B. The Condorcet Voting Paradox
1. Most advanced societies rely on democratic principles, allowing the majority to set
government policy.
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?
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 only
purchased lower priced goods. This led to a market where the only good available for sale is of
the lowest quality.
Chapter 22/Frontiers of Microeconomics ❖ 377
Voter Type
Type 1
Type 2
Type 3
Percent of Electorate
35
45
20
a. In pairwise majority voting, A would beat B, B would beat C, and C would beat A.
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.
2. He assumes that society wants a voting scheme that satisfies social properties.
a. Unanimity.
3. Arrow proved that no voting system could have all of these properties.
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.
Table 1
378 ❖ Chapter 22/Frontiers of Microeconomics
D. The Median Voter Is King
1. Example: A society is deciding how much money to spend on a public good. Each voter has a
most-preferred budget and prefers outcomes closer to his preferred budget.
2. Definition of median voter theorem: a mathematical result showing that if voters
are choosing a point along a line and each voter wants the point closest to his
preferred point, then majority rule will pick the most preferred point of the
median voter.
E. Politicians Are People Too
1. Politicians may be self-interested.
2. Some politicians may be motivated by desire for reelection and others may be motivated by
greed.
III. Behavioral Economics
A. Definition of behavioral economics: the subfield of economics that integrates the
insights of psychology.
C. People Aren’t Always Rational
1. Economists assume that human beings are always rational.
a. Firm owners maximize profit.
Figure 1
Chapter 22/Frontiers of Microeconomics ❖ 379
2. Real people are often more complex than economists assume.
3. Studies of human decision-making have found several systematic mistakes that people make.
a. People are overconfident.
D. People Care about Fairness
1. Example: the ultimatum game.
a. Two volunteers are told they are going to play a game and could win a total of $100.
b. The game begins with a coin toss, which is used to assign the volunteers to the roles of
Player A and Player B.
c. Player A’s job is to propose a division of the prize between himself and the other player.
d. After Player A makes his proposal, Player B decides whether to accept or reject it.
e. If Player B accepts the proposal, both players are paid according to the proposal. If
Player B rejects the proposal, both players receive nothing.
2. Conventional economic theory suggests that Player A should know that if he offers $1 to
Player B and keeps $99 for himself, Player B should accept it ($1 is greater than $0).
3. In reality, when the offer made to Player B is small, Player B often rejects it.
4. Knowing this, people in the role of Player A often offer a more substantial portion of the
money to Player B.
E. People Are Inconsistent over Time
1. Many times in life, people make plans for themselves but then fail to follow through.
2. The desire for instant gratification can induce a decision-maker to abandon his past plan.
380 ❖ Chapter 22/Frontiers of Microeconomics
1. The assumption of rational behavior and the consequent “seemingly irrelevant factors”
pervade traditional economics.
2. In this
New York Times
article, behavioral economist Richard Thaler discusses the importance
of considering actual behavior rather than the theorized ideal.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Buyers of life insurance will likely have higher than the average death rates. Two reasons for
this are moral hazard and adverse selection.
2. According to the median voter theorem, if each voter chooses a point closest to his preferred
3. Human decision-making can differ from the rational human being of conventional economic
Chapter Quick Quiz
1. b
Questions for Review
1. Moral hazard is the tendency of a person who is imperfectly monitored to engage in
Chapter 22/Frontiers of Microeconomics ❖ 381
2. Adverse selection is the tendency for the mix of unobserved attributes to become undesirable
3. Signaling is an action taken by an informed party to reveal private information to an
uninformed party. Job applicants may use a college diploma as a signal of ability. Screening
6. Two volunteers are chosen and a coin toss determines which volunteer is Player A and which
Problems and Applications
1. a. The landlord is the principal and the tenant is the agent. There is asymmetric information
b. The stockholders of the firm (the owners) are the principals and the top executives are
c. The insurance company is the principal and the customer is the agent. Insurance
2. Individuals who are relatively healthy may decide to forgo purchasing the policy if the
3. Saying "I love you" is likely not a good signal. To be an effective signal, the signal must be
382 ❖ Chapter 22/Frontiers of Microeconomics
4. a. Taken on its own, the policy that insurance companies must offer health insurance to
everyone who applies and charge them the same price regardless of a person’s pre-
b. The policy was included in the law to make the law equitable for all citizens. If insurance
c. The requirement that everyone must buy health insurance or pay a penalty reduces the
average person.
5. Ken is violating the property of independence of irrelevant alternatives. Adding a choice of
6. a. If the three friends use a Borda count, the Chinese restaurant gets the most votes (10);
the Italian restaurant gets 9 votes; the Mexican restaurant gets 7 votes; and the French
Chapter 22/Frontiers of Microeconomics ❖ 383
