• Asymmetric information: some people are more informed than others, affecting how they make choices and how they interact with each other

• Political economy: how markets fail and how government policy can potentially improve situations

• Behavioral economics: how human behavior can be more subtle, complex, and realistic than the one in conventional economic theory

22-1 Asymmetric Information

• Information asymmetry: a difference in access to knowledge

Hidden Actions: Principals, Agents, and Moral Hazard

• Moral hazard: the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior

• Agent: a person who performs an act for another person, called the principal

• Principal: a person for whom another person, called the agent, performs some act

  • Ex: employers are principals, workers are agents

• There are ways to reduce moral hazards

  • Better monitoring, using cameras, to record behavior.

  • Higher wages incentivize workers to work higher.

  • Delayed payment, so if workers are caught and fired, they suffer a larger penalty.

Hidden Characteristics: Adverse Selection and the Lemons Problem

• Adverse selection: the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party

• Customers are more suspicious and are likely to avoid getting a product if the seller might know something they won’t tell the buyers

Signaling to Convey Private Information

• Signaling: an action taken by an informed party to reveal private information to an uninformed party

• Signals must be less costly to the person with the higher-quality product.

  • EX: The “as seen on TV” advertisement commonly seen on many products signals a company is willing to spend money on advertising.

Screening to Uncover Private Information

• Screening: an action taken by an uninformed party to induce an informed party to reveal information

• This usually includes questioning about a product or service.

Asymmetric Information and Public Policy

• When information is not distributed equally, the market may not be as efficient.

• This justifies government action in some cases. HOWEVER:

  • The market can fix itself and the asymmetric information via signaling and screening.

  • The government may not have enough information to deal with the private properties.

  • The government is not a perfect institution.

22-2 Political Economy

• Political economy: (also known as a public choice) the study of government using the analytic methods of economics

The Condorcet Voting Paradox

• Most advanced societies rely on democracy to build government policy.

• This usually includes the majority wins, but sometimes it runs into problems

• Condorcet paradox: the failure of majority rule to produce transitive preferences for society

• The order of the items to vote on affects the outcome.

• A majority voting by itself may not tell what society really wants.

Arrow’s Impossibility Theorem

• Unanimity: If everyone prefers A to B, then A should beat B.

• Transitivity: If A beats B, and B beats C, then A should beat C.

• Independence of irrelevant alternatives: The ranking between any two outcomes A and B does not depend on third outcome C.

• No dictators: There is no person who always gets their way.

• Arrow’s 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

• No matter the voting system, there will always be a flaw.

The Median Voter Is King

• Median voter theorem: a mathematical result showing that if voters are choosing a point along a line each voter wants the point closest to his most preferred point, then majority rule will pick the most preferred point of the median voter

• A median voter is a voter in the middle of the distribution of votes.

• Politicians will move positions to the one favored by the median voter to maximize their chance of election.

Politicians Are People Too

• Politicians have motivations, selfish and selfless.

• Therefore, they may have biases.

22-3 Behavioral Economics

• Behavioral economics: the subfield of economics that integrates the insights of psychology

People Aren’t Always Rational

• Homo economicus refers to human organisms that are always rational, which is studied in economic theory.

• However, people in real life aren’t always national.

• Humans aren’t maximizers, but satisficers.

• They make decisions that are good enough, but not perfect.

• Other findings:

  • People are overconfident

  • People give too much weight to a small number of vivid observations.

  • People are reluctant to change their minds.

People Care about Fairness

• People will reject offers if they do not deem it to be fair.

People Are Inconsistent Over Time

• Consumption-saving decisions are examples of inconsistency.

• People should look for ways to commit to plans concerning the future.