22 FRONTIERS OF MICROECONOMICS
WHAT S NEW IN THE S EVENTH EDITION:
A new Case Study on Left-Digit Bias has been added and a new In the News feature on \Improve Econo mics?\
LEARNING OBJECTIVES:
By the end of this chapter, stude nts should un dersta nd:
how to exam ine problems caused by asymmetric in formati on. the market soluti ons to asymmetric in formati on.
why democratic voti ng systems may not represe nt the prefere nces of society. why people may not always behave as rati onal maximizers.
CONTEXT AND PURPOSE:
Chapter 22 is the last chapter in the microeconomics portion of the text. It is the second of two unrelated
chapters that in troduce stude nts to adva need topics in microec ono mics. These two chapters are inten ded to whet their appetites for further study in econo mics.
The purpose of Chapter 22 is to give stude nts a taste of three topics on the fron tier of microec ono mic
research. The first topic addressed is asymmetric information , a situation when one person in an econo mic relati on ship has more releva nt kno wledge tha n the other pers on does. The sec ond topic is political
economy , the application of economic tools to the understanding of the functioning of government. The third topic addressed is behavioral economics , the introduction of psychology into the study of econo mic issues.
KEY POINTS:
* In many econo mic tran sacti ons, in formati on is asymmetric. When there are hidde n acti ons, pri ncipals may
be con cer ned that age nts suffer from the problem of moral hazard. When there are hidde n
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391
392 ? Chapter 22/Frontiers of Microeconomics
characteristics, buyers may be concerned about the problem of adverse selection among the sellers. Private markets sometimes deal with asymmetric in formatio n with sig nali ng and scree ning.
? Although gover nment policy can sometimes improve market outcomes, gover nments are themselves
imperfect in stituti ons. The Con dorcet paradox shows that the majority rule fails to produce tra nsitive prefere nces for society, and Arrow's impossibility theorem shows that no vot ing system will be perfect. In many situati ons, democratic in stituti ons will produce the outcome desired by the media n voter, regardless of the prefere nces of the rest of the electorate. Moreover, the in dividuals who set gover nment policy may be motivated by self-in terest rather tha n n ati onal in terest. ? The study of psychology and econo mics reveals that huma n decisi on mak ing is more complex tha n is
assumed in conven ti onal econo mic theory. People are not always rati on al, they care about the fairness of economic outcomes (even to their own detriment), and they can be inconsistent over time.
CHAPTER OUTLINE:
This is a great chapter to get students interested in further study of economics. It is important for the students to learn that economics is a growing and developing scie nee and that econo mists are always look ing for new areas to study and new phe nomena to expla in. I.
Asymmetric In formati on
A. Many times in life, one pers on holds more kno wledge about what is going on tha n ano ther. Such
a differe nee in access to releva nt in formatio n is known as an in formati on asymmetry B. Examples
1. A worker knows more tha n his employer about the level of his work effort. This is an example of a
hidde n action. 2. A seller of a used car knows more tha n the buyer does about the car's con diti on. This is an
example of a hidden characteristic . C. When there is asymmetric in formati on, the party without the releva nt kno wledge would like to have
such kno wledge, but the other party may have an incen tive to con ceal it. D. Hidde n Acti ons: Pri ncipals, Agen ts, and Moral Hazard
1. Important Definitions
a. Definition of moral hazard: the tendency of a person who is imperfectly mon itored to en gage in dish on est or otherwise un desirable behavior.
b. Definition of agent: a person who is performing an act for another person, called the prin cipal. c.
Defin iti on of pri ncipal* a pers on for whom ano ther pers on, called the age nt, is performi ng some act.
2. The employme nt relati on ship is the classic example.
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Chapter 22/Fro ntiers of Microec ono mics ? 393
a. Workers (age nts) may be tempted to shirk their work-related resp on sibilities because their
employers (the prin cipals) do not mon itor their behavior closely. b. Employers can resp ond by provid ing better mon itori ng, pay ing higher wages, or delay ing part
of the worker's pay until later in the worker's life. 3. FYI: Corporate Man ageme nt
a. From an econo mic sta ndpo int, the most importa nt feature of the corporate form of orga ni zati
on is the separati on of own ership and con trol. b. This creates a pri ncipal -age nt problem where the shareholders are the pr in cipals and the
man agers are the age nts. c.
Man agers ' goals may not always coin cide with shareholders' goal of profit maximizati on.
d. As a result, many man agers are provided compe nsati on packages that provide incen tives to act
in the best in terest of corporate profits.
E. Hidde n Characteristics: Adverse Selectio n and the Lem ons Problem
1. Defin iti on of adverse selecti on: the tendency for the mix of uno bserved attributes to become un desirable from the sta ndpo int of an unin formed party. 2. Examples in clude the used car market, the labor market, and the market for in sura nee. 3. When markets suffer from adverse selecti on, the in visible hand does not n ecessarily work well.
a. In the used car market, owners of \
sell them at a low price. b. In the labor market, wages may be stuck at a level above the equilibrium wage, resulting in un
employme nt. c.
In in sura nee markets, buyers with low risk may decli ne to purchase in sura nee because the price is too high.
F. Sign ali ng to Con vey Private In formati on
1. Defin iti on of signaling: an acti on take n by an in formed party to reveal private in formatio n to an unin formed party. 2. Examples of Sign ali ng
a. Firms may spe nd money on advertis ing to sig nal the high quality of their products. b. Students may spend time in school to signal that they are high-ability individuals. 3. For a signal to be effective, it must be costly. However, it must be less costly (or more
beneficial) to the person or firm with the higher-quality product. 4. Case Study: Gifts as Sign als
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