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Game Theory
I. Incentive Contracting
What is “Moral Hazard?”
Post-contractual behavior (normally behavior adverse to the interests of the other party)
Game Theory
I. Incentive Contracting
•What is “adverse selection?”
A choice made available to an entire group is
chosen only by those to whom it appeals
Game Theory
I. Incentive Contracting
The choice made is typically “adverse” to the
interests of the agent providing the choice
“adverse selection”
Examples of “Adverse Selection”
• Interest Rates on Loans• Health Insurance• Term Life Insurance• Wage Rates
So, What’s The Pointabout “Adverse Selection”
• Explains some economic phenomena that are otherwise not explainable– Excess loan demand at current rates– Not charging the highest rate possible
• Explains “universal” coverage concepts– Everyone in the firm in the health plan– Those who don’t need insurance subsidize those who do need
insurance– Insurance companies want all of your business because a bad
health risk might not be a bad fire insurance risk
• Incentive for “screening”– Members of USTA or Golf Associations
Sometimes Hard To TellWhich May Be Operating
• Volvo Owners Have More Traffic Accidents– Moral Hazard?
– Adverse Selection?
• Commerce Students Get High Grades– Moral Hazard?
– Adverse Selection?
Consequences
• If both confess, they each receive 10 year sentence
• If neither confess, they each get 3 year sentence
• If one confesses but not the other, the one who confesses goes free, but the other receives a 20 year jail term.
Significance of Prisoner’s Dilemma
• Individual’s maximizing behavior may lead to suboptimal results for the group
• Implications in biology and other fields