Why does asymmetric information lead to inefficient actions

Do you do it? Surprisingly, it is likely that you would not. However, behavioral economists have pointed out that most of us evaluate outcomes relative to a reference point—here the cost of the product—and think of gains and losses as percentages rather than using actual savings.

Which view is right? Both have their advantages, but behavioral economists have at least shed a light on trying to describe and explain systematic behavior which previously has been dismissed as irrational. If you were selling a good like emeralds or used cars where imperfect information is likely to be a problem, how could you reassure possible buyers? If you were buying a good where imperfect information is a problem, what would it take to reassure you?

Buyers and sellers in the goods market rely on reputation as well as guarantees, warrantees, and service contracts to assure product quality; in the labor market, occupational licenses and certifications are used to assure competency, while in financial capital market cosigners and collateral are used as insurance against unforeseen, detrimental events.

In the goods market, the seller of a good might offer a money-back guarantee , an agreement that functions as a promise of quality.

This strategy may be especially important for a company that sells goods through mail-order catalogs or over the web, whose customers cannot see the actual products, because it encourages people to buy something even if they are not certain they want to keep it.

Bean started using money-back-guarantees in , when the founder stitched waterproof shoe rubbers together with leather shoe tops, and sold them as hunting shoes.

He guaranteed satisfaction. However, the stitching came apart and, out of the first batch of pairs that were sold, 90 pairs were returned. Bean took out a bank loan, repaired all of the shoes, and replaced them. The L. Bean reputation for customer satisfaction began to spread. Many firms today offer money-back-guarantees for a few weeks or months, but L. Bean offers a complete money-back guarantee. Anything you have bought from L. Bean can always be returned, no matter how many years later or what condition the product is in, for a full money-back guarantee.

Bean has very few stores. Instead, most of its sales are made by mail, telephone, or, now, through their website. For this kind of firm, imperfect information may be an especially difficult problem, because customers cannot see and touch what they are buying. A combination of a money-back guarantee and a reputation for quality can help for a mail-order firm to flourish. Sellers may offer a warranty , which is a promise to fix or replace the good, at least for a certain period of time.

The seller may also offer a buyer a chance to buy a service contract , where the buyer pays an extra amount and the seller agrees to fix anything that goes wrong for a set time period.

Service contracts are often used with large purchases such as cars, appliances and even houses. Guarantees, warranties, and service contracts are examples of explicit reassurance that sellers provide.

In many cases, firms also offer unstated guarantees. For example, some movie theaters might refund the cost of a ticket to a customer who walks out complaining about the show. Likewise, while restaurants do not generally advertise a money-back guarantee or exchange policies, many restaurants allow customers to exchange one dish for another or reduce the price of the bill if the customer is not satisfied.

The rationale for these policies is that firms want repeat customers, who in turn will recommend the business to others; as such, establishing a good reputation is of paramount importance. When buyers know that a firm is concerned about its reputation, they are less likely to worry about receiving a poor-quality product.

Sellers of labor provide information through resumes, recommendations, school transcripts, and examples of their work. Occupational licenses are also used to establish quality in the labor market. Occupational licenses, which are typically issued by government agencies, show that a worker has completed a certain type of education or passed a certain test.

Some of the professionals who must hold a license are doctors, teachers, nurses, engineers, accountants, and lawyers. In addition, most states require a license to work as a barber, an embalmer, a dietitian, a massage therapist, a hearing aid dealer, a counselor, an insurance agent, and a real estate broker. Some other jobs require a license in only one state. Minnesota requires a state license to be a field archeologist.

North Dakota has a state license for bait retailers. Occupational licenses have their downside as well, as they represent a barrier to entry to certain industries. This makes it more difficult for new entrants to compete with incumbents, which can lead to higher prices and less consumer choice. In industries that require licenses, the government has decided that the additional information provided by licenses outweighs the negative effect on competition.

Many advertisements seem full of imperfect information—at least by what they imply. Driving a certain car, drinking a particular soda, or wearing a certain shoe are all unlikely to bring fashionable friends and fun automatically, if at all. The government rules on advertising, enforced by the Federal Trade Commission FTC , allow advertising to contain a certain amount of exaggeration about the general delight of using a product.

They, however, also demand that if a claim is presented as a fact, it must be true. Legally, deceptive advertising dates back to the s when Colgate-Palmolive created a television advertisement that seemed to show Rapid Shave shaving cream being spread on sandpaper and then the sand was shaved off the sandpaper.

What the television advertisement actually showed was sand sprinkled on Plexiglas—without glue—and then scraped aside by the razor. So they filled a bowl with marbles and poured the soup over the top, so that the bowl appeared to be crammed with vegetables. In the late s, the Volvo Company filmed a television advertisement that showed a monster truck driving over cars, crunching their roofs—all except for the Volvo, which did not crush. However, the FTC found in that the roof of the Volvo used in the filming had been reinforced with an extra steel framework, while the roof supports on the other car brands had been cut.

The FTC objected, and in the company agreed to stop running the advertisements. Language and images that are exaggerated or ambiguous, but not actually false, are allowed in advertising. Sometimes workers also receive lower pay during this trial period. Another approach is to require a cosigner on a loan; that is, another person or firm who legally pledges to repay some or all of the money if the original borrower does not do so.

The uneven knowledge causes the price and quantity of goods or services in a market to shift. For example, if a bank set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance and high activity customers.

The individual price would generate a low profit for the bank. In addition to adverse selection, moral hazards are also a result of asymmetric information. A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk. A moral hazard can occur when the actions of one party may change to the detriment of another after a financial transaction.

In relation to asymmetric information, moral hazard may occur if one party is insulated from risk and has more information about its actions and intentions than the party paying for the negative consequences of the risk. For example, moral hazards occur in employment relationships involving employees and management. When a firm cannot observe all of the actions of employees and managers there is the chance that careless and selfish decision making will occur.

Moral Hazard : An insured driver getting into a car accident is an example of a moral hazard. The driver will take risks because the cost is not directly felt due to a transaction.

The insurance company pays for the accident and not the driver. Asymmetric information starts the downward economic spiral for a firm. A lack of equal information causes economic imbalances that result in adverse selection and moral hazards.

All of these economic weaknesses have the potential to lead to market failure. The principle-agent problem agency dilemma exists when conflicts of interest arise between a principal and an agent in a business setting. In economics, the principal-agent problem also known as an agency dilemma exists when conflicts of interest arise between a principal and an agent in a business setting.

Conflicts usually exist when contracts are written due to uncertainty and risk taken on by both parties. The principal hires the agent to perform specific to duties that represent its best interest. Examples of relationships that can experience the principal-agent problem include:. Principle agent problem : The diagram shows the basic idea of the principle agent problem. P is the principle and A is the agent. It clearly illustrates the working relationship between the principle and the agent while highlighting the presence of business partnership as well as self-interest.

The conflict of interest potentially arises in almost any context where one party is being paid by another to do something, whether it is in formal employment or a negotiated deal. The two parties have different interests and asymmetric information. In order to minimize and control economic conflict, principals and agents design and agree on a contract.

It serves as a guide and agreement to safeguard the best interests of both parties. In the linear model w is the wage, a is a constant, e is the unobserved effort, x is the unobserved exogenous effects on outcomes, and y is the observed exogenous effects; while g and a represent the weight given to y , and the base salary. A business contract creates a straightforward connection between agent performance and profitability. This connection sets the standard for judging the performance of the agent.

In business relationships, the principal will use performance evaluations to ensure that the agent is fulfilling the necessary duties. There are two forms of performance evaluation:. Incentive structures are used in business relationship in order to bridge the gap between best interests of the principal and the agent. Principals offer various incentive structures, which are rewards or motivating factors that drive the agent to work in the best interest of the principal and complete tasks efficiently.

It is usually in best interest of both parties to work together. For the principal, agent inefficiency results in sub-optimal results and low welfare. For the agent, efficiency is important in order to receive payment for work completed.

Public choice may not lead to an economically efficient outcomes due to who votes, why they vote, and in what system they vote. A voting system is a method by which voters choose between multiple options, usually in an election or policy referendum. The system enforces rules to ensure valid voting, accurate tabulation, and a final result. Common voting systems include majority rule, proportional representation, or plurality voting. The study of voting systems is called voting theory.

Voting theory is a subfield of economics. No matter what voting system is used, the act of voting gives the public the ability to choose a candidate or influence a decision. Obviously, when voting takes place not everyone will agree with the outcome, but everyone has the ability to participate in the process. In an increasingly complex world, individual decision making often relies on the advice given by experts, and a potential principal-agent problem can occur whenever decision makers rely on advice from others with more knowledge than they have.

For example, the shareholders of firms, the principals, usually delegate responsibility for day-to-day decision making to appointed managers, the agents. This creates a situation of asymmetric knowledge, with managers knowing much more than the shareholders, and raises the possibility of inefficiencies, especially when shareholders and managers have different objectives. Moral hazard, which we saw earlier, is the name given to the negative behaviour that can arise from an individual being insured.

When an individual, group, or even an entire economy is insured more risks may be taken than if they are not insured. For example, individuals who take out dental insurance may follow a less rigorous oral hygiene regime than those who do not. The term moral hazard was first used in the insurance industry, but it can be applied to many situations.

Firms may provide misleading information about products, such as producers of cosmetics claiming to make people beautiful, holiday brochures making resorts appear more attractive, and car drivers not knowing how much pollution they are creating. Clearly, government has a considerable role in trying to ensure that some of these information failures are reduced or eliminated.

The two basic strategies are to increase both the supply of, and demand for, information. Behavioural economists argue that small nudges can be used to counteract the effect of misleading or overly complex information.

One problem is that in certain situations individuals may not be able to exert self-control, and select less than healthy choices. Hence, although an individual may be over-weight, self-control may not be exerted, and the individual eats an amount larger than is optimal for their immediate health and life expectancy. Read more.

Stagflation is a combination of high inflation, high unemployment, and stagnant economic growth. Because inflation isn't supposed to occur in a weak economy, stagflation is an unnatural situation.

Slow growth prevents inflation in a normal The laissez-faire economic theory centers on the restriction of government intervention in the economy.