SummaryIn this LP we cover the implications of asymmetrical information, looking at the most important examples. We start by looking at adverse selection, then we learn more about moral hazard.
One option for mitigating problems derived from asymmetric information is designing your contract carefully so that whoever buys into it has less to gain from being a lemon. There are many practical implications for this, of which the most clear is probably in the insurance market, where making those insured pay part of the pay out in case of a claim can not only reduce adverse selection, but also moral hazard (by only attracting the safer drivers and also making sure they park more carefully).
Another practical example can be found in the labour market, with variable salaries, commissions and bonuses. Million pound payouts to disgraced bankers may by now be infamous, but when hiring somebody they really help mitigate the risk of having hired somebody who slipped through the signalling net. Not only does it mean that if you do hire a lemon by mistake you’ll have to pay them less, but in theory, they will work harder (limiting moral hazard) and, curiously, you’ll attract the best. Supposing the average salary for a financial analyst is 50.000€ and you offer 20.000€ plus a 50.000€ variable bonus based on performance, the lemons will slide towards the more secure end of the job market, preferring to net their 50.000€. Those that are truly bright will go for the 20 + 50, because if their performance is measured fairly they will earn more than the market average. This deals with the adverse selection side, and, in fact, accepting this type of wage structure can be a form of signalling in itself.
By now, the idea should be clear. Incentives work either by mitigating the effects of:
- Moral hazard: contracts that have incentives built in to make us either work harder, drive safer, or stop smoking because by the way the contract is designed, we either stand to pay less or earn more by doing what is in the ‘weaker’ agents’ interests.
- Adverse selection: contracts that weed out the lemons by making them attractive only to those who are safer, healthier or cleverer by offering above average conditions for those who perform above market average but much worse conditions for those who perform below market average.