CH 22 Frontiers of Microeconomics

N.
GREGORY MANKIW
PRINCIPLES OF
MICROECONOMICS
Eighth Edition
CHAPTER Frontiers of
22 Microeconomics
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1
management system for classroom use.
Look for the answers to these questions:
• How does asymmetric information affect
market outcomes?
• How can market participants reduce the
resulting problems?
• Why might democratic voting systems fail to
represent the preferences of society?
• Why do people not always behave as
rational maximizers?
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 2
Introduction
• Microeconomics continues to evolve.
• This chapter introduces three active areas
of research:
– Asymmetric information
– Political economy
– Behavioral economics
Asymmetric Information
• Information asymmetry:
– A difference in two or more parties’ access
to relevant knowledge
• Hidden actions
– One person knows more than another
about an action he or she is taking.
• Hidden characteristics
– One person knows more than another
about the attributes of a good he is selling.
Hidden Actions
and Moral Hazard
• Moral hazard:
– Tendency of a person who is imperfectly
monitored to engage in dishonest or
otherwise undesirable behavior
• Moral hazard problems:
– Workers sometimes shirk their
responsibilities because their employer
cannot continually monitor their effort and
performance.
Hidden Actions
and Moral Hazard
• Moral hazard problems:
– Someone whose property is insured may
not try as hard to protect it from
theft/damage.
– While the parents are out, the babysitter
may spend more time watching videos
than watching the children.
The Principal-Agent Problem
• Agent:
– A person who is performing a task on
someone else’s behalf (e.g., a worker)
• Principal:
– The person for whom this action is being
performed (e.g., an employer)
The Principal-Agent Problem
• The principal – agent problem
– When the principal cannot perfectly
monitor the agent’s behavior, there is a
risk (“hazard”) that the agent may do
something undesirable (“immoral”).
– Example: Worker may play video games
or surf the web while on the clock.
How Principals May Respond
• Better monitoring
– Hidden cameras to increase the chance of
detecting undesirable behavior
• Higher wages
– Efficiency wages to increase the penalty for
being caught shirking
• Delayed payment
– Firms delay payment (e.g., year-end bonuses)
to increase the penalty for being caught shirking
Corporate Management
Principal-Agent Problem
• The separation of ownership and control
of corporations creates a principal-agent
problem:
– Principals: the shareholders, pay
managers to maximize the firm’s profits
– Agents: the managers, may pursue their
own objectives
• Solution: need to align managers’
interests with the firm’s goals
Corporate Management
Principal-Agent Problem
• Solution:
– Shareholders hire a board of directors to
oversee management, create incentives
for management to pursue the firm’s goals
instead of their own.
– Corporate managers sometimes sent to
jail for taking advantage of shareholders.
Hidden Characteristics and
Adverse Selection
• Adverse selection
– Arises when the seller knows more than the buyer
about the good being sold.
• Example 1: The market for used cars
– The seller knows more than the buyer about the
quality of the car being sold.
– Owners of “lemons” are more likely to put their
vehicles up for sale.
– So buyers are more likely to avoid used cars.
– Owners of good used cars are less likely to get a
fair price, so may not bother trying to sell
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Hidden Characteristics and
Adverse Selection
• Example 2: Insurance
– Buyers of health insurance know more about
their health than health insurance companies.
– People with hidden health problems have more
incentive to buy insurance policies.
– So, prices of policies reflect the costs of a
sicker-than-average person.
– These prices discourage healthy people from
buying insurance.
The information asymmetry prevents some
mutually beneficial trades.
Market Responses to
• Signaling:
– Action taken by an informed party to reveal
private information to an uninformed party
– Individual selling a good used car provides all
receipts for work done on car.
– Dealership provides warranties on used cars.
– Firms spend huge sums on advertising to
signal product quality to buyers.
– Highly competent workers get college degree
to signal their quality to employers.
Market Responses to
• Screening:
– Action taken by an uninformed party to induce
informed party to reveal private information
– Health insurance company requires physical
exam before selling policy.
– Buyer of a used car requires inspection by a
mechanic.
– Auto insurance company charges lower
premiums to drivers willing to accept a larger
deductible -most likely the safer drivers.
and Public Policy
• Asymmetric information
– May prevent market from allocating
resources efficiently
• Public policy may not be able to improve
on the market outcome:
– Private markets can sometimes deal with the
problem using signaling or screening.
– The government rarely has more information
than private parties.
– The government itself is an imperfect institution.
Behavioral Economics
• Behavioral economics:
– Subfield of economics that integrates
the insights of psychology
– People aren’t always as rational as traditional
economic models assume.
• Herbert Simon viewed humans as satisficers,
people who make choices that are merely
“good enough” rather than optimal.
• Other economists have suggested that
people are only “near rational” or exhibit
“bounded rationality.”
People Aren’t Always Rational
• Studies find that people make systematic
mistakes:
– People are overconfident.
– People give too much weight to a small
number of vivid observations.
– People are reluctant to change their
minds.
Even though people are not always rational, the
assumption that they are is usually a good
approximation for economic modeling.
People Care About Fairness
• People’s choices
– Sometimes influenced more by their
sense of fairness than self-interest.
• Example: The ultimatum game
– Two players who do not know each other
have a chance to share a prize of $100.
• Player A decides what portion of the prize to
give to player B.
• B must accept the split or both get nothing.
• Predicted outcome (rational players)
– A would propose a 99-1 split and B would
accept, because $1 is better than nothing.
• Actual outcomes (experiments)
– B usually rejects lopsided splits like 99-1
as wildly unfair.
– Expecting this, A usually proposes giving
$30 or $40 to B.
– B views this as unfair, but not so much as to
abandon his self-interest, so B accepts.
• The results of the ultimatum game
– Apply in other situations.
• Example:
– A firm may pay above-equilibrium wages
during profitable years to be fair,
• Or to avoid appearing unfair and risking
retaliation from workers.
People Are Inconsistent Over Time
• People tend to prefer instant gratification
– Even when delaying would increase the
gratification
– Result: People fail to follow through on plans to
do things that are dreary, take effort, or cause
discomfort.
• E.g., people often save less than they plan
– To help follow through, people look for ways to
commit themselves to their plans.
• E.g., worker has money taken out of
paycheck before he ever sees it
Conclusion
Markets are usually a good way to organize
economic activity.
Governments can sometimes improve market
outcomes.
• Research illustrates some caveats:
– Consumers aren’t always rational
– Market outcomes may not be best when
information is asymmetric
– Government solutions are not always ideal
Summary
• In many transactions, information is
asymmetric.
• When there are hidden actions, principals may
be concerned that agents suffer from the
problem of moral hazard.
• When there are hidden characteristics, buyers
may be concerned about the problem of
adverse selection among the sellers.
• Private markets sometimes deal with
asymmetric information with signaling and
screening.
Summary
• Governments are imperfect institutions.
• The Condorcet paradox shows that majority
rule fails to produce transitive preferences for
society.
• Arrow’s impossibility theorem shows that no
voting system will be perfect.
• In many situations, majority voting will produce
the outcome desired by the median voter,
regardless of the preferences of everyone else.
• Policymakers may be motivated by self-interest
rather than the national interest.
Summary
• The study of psychology and economics
reveals that human decision making is more
complex than is assumed in conventional
economic theory.
• People are not always rational, they care
about the fairness of economic outcomes
(even to their own detriment), and they can be
inconsistent over time

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