Varian: Intermediate microeconomics
Disclaimer. Don't rely on these old notes in lieu of reading the literature, but they can jog your memory. As a grad student long ago, my peers and I collaborated to write and exchange summaries of political science research. I posted them to a wiki-style website. "Wikisum" is now dead but archived here. I cannot vouch for these notes' accuracy, nor can I say who wrote them.
Varian. 2002. Intermediate microeconomics: A modern approach (5th ed). W.W. Norton.
A very nice summary of the "market for lemons" problem, and a discussion of how the presence of inferior goods creates an externality that affects sellers of quality goods and those who want to buy them (since inferior goods drive quality goods out of the market). So adverse selection is an externality problem.
Moral hazard: if your insurance takes all the risk, you lose the incentive to avoid the costly behavior. Again, an externality problem. Providing insurance creates an externality in that it leads to the behavior you are trying to prevent.
Summary (from end of chapter):
- Imperfect and asymmetric information can lead to drastic differences in the nature of market equilbrium.
- Adverse selection refers to situations where the type of the agents is not observable so that one side of the market has to guess the type or quality of a product based on the behavior of the other side of the market.
- In markets involving adverse selection too little trade may take place. In this case it is possible that everyone can be made better off by forcing them to transact. [e.g. have government force everyone to buy health insurance through taxation, or have a corporation provide health insurance for all employees]
- Moral hazard refers to a situation where one side of the market can't observe the actions of the other side.
- Signaling refers to the fact that when adverse selection or moral hazard are present some agents will want fo invest in signals that will differentiate them from other agents.
- Investment in signals may be privately beneficial but publically wasteful. On the other hand, investmcnt in signals may help to solve problems due to asymmetric information.
- Eficient incentive schemes (with perfect observability of effort) leave the worker as the residual claimant. This means that the worker will equate marginal benefits and marginal costs.
- But if information is imperfect this is no longer true. In general, an incentive scheme that shares risks as well as providing incentives will be appropriate.