CHAPTER 20 Decisions Involving Private Information

Do you know the whole truth?

-

This is a sample content for Long ALT text

Chapter Objective

Learn how to make decisions when you don’t have all the facts.

• 20.1 Adverse Selection When Sellers Know More Than Buyers

  Discover how sellers’ private information can reduce the quality of goods offered for sale and distort market outcomes.

• 20.2 Adverse Selection When Buyers Know More Than Sellers

  Discover how buyers’ private information can drive up sellers’ costs and distort market outcomes.

• 20.3 Moral Hazard: The Problem of Hidden Actions

  Recognize and solve problems that arise when some actions are hidden.

What happens when you know something that others don’t? Or they know something you don’t? For instance, you know better than your boss how you spend your time at work—whether you stay on task or goof off checking Facebook. When you buy a used car, the owner knows things you don’t—whether the car has been well cared for, if it sputters rather than starts on cold mornings, or if it’s been in an accident. And you know better than your health insurer whether you’re healthy and how likely you are to need medical care.

Trouble arises when differences in information collide with conflicting incentives. Your boss wants you to work hard; you want to take it easy. You want a good car; the seller just wants to close the deal. Your insurer hopes you’re healthy; you know that you’re not. You can’t know for sure when someone is telling you the whole truth, and others can’t know for sure when you are. This creates a fog of misinformation that has far-reaching effects. It distorts supply and demand and leads to inefficient outcomes. You may be a desirable buyer, or you may be selling desirable goods—but how would I know? I don’t. Information problems can cause a market to break down, making it hard for you to buy what you want and for sellers to connect with the right buyers.

Our task in this chapter is figuring out how best to do business when buyers or sellers have information that the other side can’t easily get. We’ll assess how to make the best choices possible in the face of this information imbalance. And we will develop some strategies to restore the transparency and trust needed to help you do business. You’ll be better able to negotiate an employment relationship that works better for you and your boss, become a savvier shopper, and get the best possible price on insurance. We’ll proceed in three parts. First, we’ll assess what happens when sellers know something about their goods that buyers don’t. Next, we’ll evaluate what happens when buyers know something about themselves that sellers don’t. Finally, we’ll analyze what happens when actions can’t be observed. By the end of this chapter you’ll have all the information you need to make good choices even when you don’t have all the information you want.