PowerPoint Presentation

Economics 410Managerial Economics

TuesdaySeptember 7, 1999Moral HazardAdverse Selection1Game TheoryAsymmetric InformationMoral HazardAdverse Selection

I. Incentive Contracting2Game TheoryMoral Hazard

I. Incentive Contracting3Game Theory

I. Incentive ContractingWhat is Moral Hazard?Post-contractual behavior (normally behavior adverse to the interests of the other party)4Examples of Moral HazardFire InsuranceTerm Life Insurance (?)Health InsuranceEconomics 410

5Examples of Moral Hazard

The Labor Market? Tenure? Shirking?6Game TheoryMoral HazardAdverse Selection

I. Incentive Contracting7Game Theory

I. Incentive ContractingWhat is adverse selection?A choice made available to an entire group ischosen only by those to whom it appeals8Game Theory

I. Incentive ContractingThe choice made is typically adverse to theinterests of the agent providing the choiceadverse selection9Examples of Adverse SelectionInterest Rates on LoansHealth InsuranceTerm Life InsuranceWage Rates

10So, Whats The Pointabout Adverse SelectionExplains some economic phenomena that are otherwise not explainableExcess loan demand at current ratesNot charging the highest rate possibleExplains universal coverage conceptsEveryone in the firm in the health planThose who dont need insurance subsidize those who do need insuranceInsurance companies want all of your business because a bad health risk might not be a bad fire insurance riskIncentive for screeningMembers of USTA or Golf Associations11Game TheoryAsymmetric InformationMoral HazardAdverse Selection

I. Incentive Contracting12Sometimes Hard To TellWhich May Be OperatingVolvo Owners Have More Traffic AccidentsMoral Hazard?Adverse Selection?Commerce Students Get High GradesMoral Hazard?Adverse Selection?

13One More GameThe Prisoners DilemmaTwo Robbers Get CaughtDecision: Confess or Dont Confess14ConsequencesIf both confess, they each receive 10 year sentenceIf neither confess, they each get 3 year sentenceIf one confesses but not the other, the one who confesses goes free, but the other receives a 20 year jail term.15PossibilitiesConfessDontConfessDont3 yrs10 yrsFree20 yrs20 yrsFree16Significance of Prisoners DilemmaIndividuals maximizing behavior may lead to suboptimal results for the groupImplications in biology and other fields17The End18