VII Journal

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit VII At the end of this unit, you should be able to:

7. Explain the implications of uncertainty in managerial decision-making. 7.3 Compare moral hazard and adverse selection.

Required Unit Resources Chapter 19: The Problem of Adverse Selection (ULO 7.3) Chapter 20: The Problem of Moral Hazard (ULO 7.3) Unit Lesson Lesson: Adverse Selection and Moral Hazard (ULO 7.3) This lesson introduces you to the topics covered in this unit: adverse selection and moral hazard. Problems of uncertainty and incomplete information can create a variety of problems for business decision- making. Two of those problems, adverse selection and moral hazard, will be the topics of this lesson. They are both types of information asymmetries, where one party to an interaction has more information than the other party.

Adverse Selection Adverse selection occurs when one party is better informed about product quality than the other party. This information difference specifically leads people to self-select in or out of a particular group, leading to potentially problematic outcomes. To see these outcomes, consider the example of insurance. Insurance is intended to cover people when something unexpected happens. People pay into a pool of money (managed by an insurance company) and are then paid out if events covered by their insurance happen. You likely have experience with health insurance, car insurance, and life insurance. The model works if there are more people paying into the pool than drawing from the pool. People benefit from insurance if an unexpected event happens to them and people lose if an event does not happen to them; although, there is still benefit from security against risk even if the event does not happen. Ultimately, insurance works because people tend to be risk-averse. Recall the coin-flipping example from Unit VI. Since the expected value of the game is $0, a risk-neutral person is completely indifferent to playing the game because they will expect to win nothing and lose nothing. A risk-averse person would not want to participate in the coin-flipping activity because they have a greater fear of losing than hope of winning a dollar. A risk-seeking person puts more weight on the positive outcome from a risk so they would be more likely to engage in the coin-flipping activity. You might see the potential adverse selection problem with insurance. People with a low probability of the event happening to them are less likely to join the insurance pool while people with a high probability of the event happening to them are more likely to join the insurance pool. This happens when young, healthy people opt not to buy health insurance. It is why life insurance companies market to young people to buy insurance now (that is, buy it when they likely do not need it). A pool of people made up primarily of people likely to use insurance will put the insurance company out of business.

UNIT VII STUDY GUIDE Adverse Selection and Moral Hazard

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

Consider other types of insurance and how well they work. Who is likely to buy vision insurance? Most likely people who already need glasses. As a result, there is not a very good cost-benefit to the consumer for vision insurance. That is, the amount consumers pay in premiums is close to the maximum benefit they can get from their insurance each year.

Protections Against Adverse Selection As a consumer, the best way to deal with adverse selection is to recognize when it will likely happen, which group you are likely to be in, and make your decisions accordingly. If you have perfect vision, for example, there is not a need to get vision insurance. Consumer perception of adverse selection can also be problematic for companies. In the market for used cars, consumers might believe that the only reason somebody would look to sell their used car is if something is wrong with it. That is, consumers view the market for used cars as an adverse selection problem. Given those assumptions, consumers would decrease the amount they are willing to pay for a used car. So how can companies overcome these consumer perceptions and consumer selection problems? One way companies can overcome adverse selection is by screening consumers. Life insurance companies screen prospective customers by asking for medical history. Car insurance companies consider past driving record, age, gender, and marital status in setting premiums (or even if they will offer insurance) for customers. Going back to the used car market, consumers can request a mechanic review of a car to screen bad cars (or, to overcome the problem on their end, the seller offers certification of the car passing an inspection). Another way to overcome the adverse selection problem is with signaling. Signaling occurs when one party attempts to reveal information about themselves that other parties cannot duplicate. Education, for example, is part signal. Getting a degree is a signal to potential employers of a certain level of competence and problem-solving ability. People without the same level of competence and problem solving would not, the thinking goes, be able to earn the degree. From the business perspective, advertising and branding can serve as signals. Businesses would not bother to spend the money on advertising unless their product was worth advertising. Similarly, established brand names send a signal to consumers that there is a reason the brand has been established. Whether the brand is for low cost or for high quality, consumers can feel comfortable knowing the brand will be as expected. Adverse selection can happen in areas other than insurance. It can be particularly important for data analysis. Imagine you need to figure out how much interest there is in a new product or service and you decide to survey people to get your data. You go to the mall and ask people if they would like to participate in your survey. Because you can only survey people who are willing to take your survey, you will only get responses from people who opt to give up some of their shopping time to take your survey. Who might this be? It might be mostly people who are just out for leisurely entertainment and do not have anything better to do. People who have a high value for their time naturally opt out of taking your survey, and your data will not include information on those types of people. That is, your survey will be biased.

Moral Hazard Another type of asymmetry is moral hazard. One quick point on moral hazard is that it does not really have anything to do with morals. Students sometimes fixate on the word moral and assume it has to do with people acting immorally. It does not. Some may view the actions in a moral hazard as immoral, but moral hazard still refers to specific incentives and actions, not morality generally. Moral hazard occurs when one party does not bear the risks for the actions they take. Turning back to insurance, a person with health insurance might be more likely to engage in risky activity knowing they will not have to pay all of their medical bills. With car insurance, a driver might be less careful on the road knowing their car would be replaced by the insurance company if they got into an accident. Moral hazard and adverse selection can often explain similar events but the explanations are different. Adverse selection would suggest that risky drivers would be more likely to buy cars with airbags. Moral hazard would suggest that because a car has air bags, drivers are likely to take more risks when driving. Ultimately, the difference is that adverse selection is about hidden information while moral hazard is about hidden actions.

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

Another type of moral hazard is when firms hire workers, but monitoring their behavior is either difficult or costly. Without monitoring, employees can shirk in their job duties without repercussions. Potential shirking is one reason to pay salespeople commission. Salespeople who shirk and do not make sales will not earn much income. Shirking costs both the firm and the employee money as firms have less desire to pay workers in fear they will shirk or have less money to pay workers because they have to pay for monitoring. Shirking leads into the principal-agent problem, which will be covered in Unit VIII. Moral hazard also played an important role in the 2008 financial crisis. Lending money already involves some moral hazard. Borrowers engage in riskier activity with someone else’s money than they are willing to engage in with their own money (the borrower, after all, is not risking their own money when they make a big purchase, they are only risking a future promise to pay the money; a promise they can break). In the financial crisis, however, banks were bailed out for their risky decisions in a variety of ways. First, their loans were often insured by Fannie Mae and Freddie Mac. Second, many mortgage companies would write the loan and then sell the loan so they were not the ones actually servicing the loan. The company would get paid for writing the loan but then not bear any risk for how the loan actually performed. Third, when the financial crisis started, the government bailed out banks and other financial institutions (and the automobile industry).

Protections Against Moral Hazard Sometimes, governments attempt to regulate away risky behavior. This is the case with the federal deposit insurance and banks. Because bank deposits are insured, consumers do not have to worry if their bank goes under. They will still get their money. That leads consumers to ignore bank risk when deciding where to deposit their money and instead focus on which bank offers the best interest rates. Banks can only offer higher interest rates if they are able to generate a higher return on their loans. That is, the riskier loans banks make, the more interest they earn, and the more interest they can pay to their customers to attract more deposits. Since banking regulators are well aware of these incentives, they attempt to regulate bank lending activity. When firms engage in risky activity but are bailed out when the risks do not work out, there is no incentive for the firms to change their behavior and engage in less risky behavior. Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information.

In order to check your understanding of concepts covered in this unit, complete the Unit VII Check for Understanding activity. Unit VII Activity Alternate Format PDF NOTE: Be sure to maximize your internet browser so that no part of the presentation gets cut off.

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit VII At the end of this unit, you should be able to:

7. Explain the implications of uncertainty in managerial decision-making. 7.3 Compare moral hazard and adverse selection.

Required Unit Resources Chapter 19: The Problem of Adverse Selection (ULO 7.3) Chapter 20: The Problem of Moral Hazard (ULO 7.3) Unit Lesson Lesson: Adverse Selection and Moral Hazard (ULO 7.3) This lesson introduces you to the topics covered in this unit: adverse selection and moral hazard. Problems of uncertainty and incomplete information can create a variety of problems for business decision- making. Two of those problems, adverse selection and moral hazard, will be the topics of this lesson. They are both types of information asymmetries, where one party to an interaction has more information than the other party.

Adverse Selection Adverse selection occurs when one party is better informed about product quality than the other party. This information difference specifically leads people to self-select in or out of a particular group, leading to potentially problematic outcomes. To see these outcomes, consider the example of insurance. Insurance is intended to cover people when something unexpected happens. People pay into a pool of money (managed by an insurance company) and are then paid out if events covered by their insurance happen. You likely have experience with health insurance, car insurance, and life insurance. The model works if there are more people paying into the pool than drawing from the pool. People benefit from insurance if an unexpected event happens to them and people lose if an event does not happen to them; although, there is still benefit from security against risk even if the event does not happen. Ultimately, insurance works because people tend to be risk-averse. Recall the coin-flipping example from Unit VI. Since the expected value of the game is $0, a risk-neutral person is completely indifferent to playing the game because they will expect to win nothing and lose nothing. A risk-averse person would not want to participate in the coin-flipping activity because they have a greater fear of losing than hope of winning a dollar. A risk-seeking person puts more weight on the positive outcome from a risk so they would be more likely to engage in the coin-flipping activity. You might see the potential adverse selection problem with insurance. People with a low probability of the event happening to them are less likely to join the insurance pool while people with a high probability of the event happening to them are more likely to join the insurance pool. This happens when young, healthy people opt not to buy health insurance. It is why life insurance companies market to young people to buy insurance now (that is, buy it when they likely do not need it). A pool of people made up primarily of people likely to use insurance will put the insurance company out of business.

UNIT VII STUDY GUIDE Adverse Selection and Moral Hazard

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

Consider other types of insurance and how well they work. Who is likely to buy vision insurance? Most likely people who already need glasses. As a result, there is not a very good cost-benefit to the consumer for vision insurance. That is, the amount consumers pay in premiums is close to the maximum benefit they can get from their insurance each year.

Protections Against Adverse Selection As a consumer, the best way to deal with adverse selection is to recognize when it will likely happen, which group you are likely to be in, and make your decisions accordingly. If you have perfect vision, for example, there is not a need to get vision insurance. Consumer perception of adverse selection can also be problematic for companies. In the market for used cars, consumers might believe that the only reason somebody would look to sell their used car is if something is wrong with it. That is, consumers view the market for used cars as an adverse selection problem. Given those assumptions, consumers would decrease the amount they are willing to pay for a used car. So how can companies overcome these consumer perceptions and consumer selection problems? One way companies can overcome adverse selection is by screening consumers. Life insurance companies screen prospective customers by asking for medical history. Car insurance companies consider past driving record, age, gender, and marital status in setting premiums (or even if they will offer insurance) for customers. Going back to the used car market, consumers can request a mechanic review of a car to screen bad cars (or, to overcome the problem on their end, the seller offers certification of the car passing an inspection). Another way to overcome the adverse selection problem is with signaling. Signaling occurs when one party attempts to reveal information about themselves that other parties cannot duplicate. Education, for example, is part signal. Getting a degree is a signal to potential employers of a certain level of competence and problem-solving ability. People without the same level of competence and problem solving would not, the thinking goes, be able to earn the degree. From the business perspective, advertising and branding can serve as signals. Businesses would not bother to spend the money on advertising unless their product was worth advertising. Similarly, established brand names send a signal to consumers that there is a reason the brand has been established. Whether the brand is for low cost or for high quality, consumers can feel comfortable knowing the brand will be as expected. Adverse selection can happen in areas other than insurance. It can be particularly important for data analysis. Imagine you need to figure out how much interest there is in a new product or service and you decide to survey people to get your data. You go to the mall and ask people if they would like to participate in your survey. Because you can only survey people who are willing to take your survey, you will only get responses from people who opt to give up some of their shopping time to take your survey. Who might this be? It might be mostly people who are just out for leisurely entertainment and do not have anything better to do. People who have a high value for their time naturally opt out of taking your survey, and your data will not include information on those types of people. That is, your survey will be biased.

Moral Hazard Another type of asymmetry is moral hazard. One quick point on moral hazard is that it does not really have anything to do with morals. Students sometimes fixate on the word moral and assume it has to do with people acting immorally. It does not. Some may view the actions in a moral hazard as immoral, but moral hazard still refers to specific incentives and actions, not morality generally. Moral hazard occurs when one party does not bear the risks for the actions they take. Turning back to insurance, a person with health insurance might be more likely to engage in risky activity knowing they will not have to pay all of their medical bills. With car insurance, a driver might be less careful on the road knowing their car would be replaced by the insurance company if they got into an accident. Moral hazard and adverse selection can often explain similar events but the explanations are different. Adverse selection would suggest that risky drivers would be more likely to buy cars with airbags. Moral hazard would suggest that because a car has air bags, drivers are likely to take more risks when driving. Ultimately, the difference is that adverse selection is about hidden information while moral hazard is about hidden actions.

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

Another type of moral hazard is when firms hire workers, but monitoring their behavior is either difficult or costly. Without monitoring, employees can shirk in their job duties without repercussions. Potential shirking is one reason to pay salespeople commission. Salespeople who shirk and do not make sales will not earn much income. Shirking costs both the firm and the employee money as firms have less desire to pay workers in fear they will shirk or have less money to pay workers because they have to pay for monitoring. Shirking leads into the principal-agent problem, which will be covered in Unit VIII. Moral hazard also played an important role in the 2008 financial crisis. Lending money already involves some moral hazard. Borrowers engage in riskier activity with someone else’s money than they are willing to engage in with their own money (the borrower, after all, is not risking their own money when they make a big purchase, they are only risking a future promise to pay the money; a promise they can break). In the financial crisis, however, banks were bailed out for their risky decisions in a variety of ways. First, their loans were often insured by Fannie Mae and Freddie Mac. Second, many mortgage companies would write the loan and then sell the loan so they were not the ones actually servicing the loan. The company would get paid for writing the loan but then not bear any risk for how the loan actually performed. Third, when the financial crisis started, the government bailed out banks and other financial institutions (and the automobile industry).

Protections Against Moral Hazard Sometimes, governments attempt to regulate away risky behavior. This is the case with the federal deposit insurance and banks. Because bank deposits are insured, consumers do not have to worry if their bank goes under. They will still get their money. That leads consumers to ignore bank risk when deciding where to deposit their money and instead focus on which bank offers the best interest rates. Banks can only offer higher interest rates if they are able to generate a higher return on their loans. That is, the riskier loans banks make, the more interest they earn, and the more interest they can pay to their customers to attract more deposits. Since banking regulators are well aware of these incentives, they attempt to regulate bank lending activity. When firms engage in risky activity but are bailed out when the risks do not work out, there is no incentive for the firms to change their behavior and engage in less risky behavior. Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information.

In order to check your understanding of concepts covered in this unit, complete the Unit VII Check for Understanding activity. Unit VII Activity Alternate Format PDF NOTE: Be sure to maximize your internet browser so that no part of the presentation gets cut off.