Asymmetric Information
Asymmetric information is one of the most common causes of a market failure. It occurs where one party in a transaction has “imperfect knowledge”, ie. Both parties don’t have an access to the same amount of relevant information . This creates an imbalance of power in the transaction, which can sometimes lead to an unsuccessful transaction and/or market failures. An example of this is in the second-hand car market. The vendor of a car has full knowledge (perfect information) about the car’s history and condition. The potential buyer does not have firsthand knowledge regarding the car’s history or condition and is reliant on information from the seller. The potential buyer may be unable to rely upon the information from the seller, which can frustrate a sale.
Asymmetric information is one of the most common causes of a market failure. It occurs where one party in a transaction has “imperfect knowledge”, ie. Both parties don’t have an access to the same amount of relevant information . This creates an imbalance of power in the transaction, which can sometimes lead to an unsuccessful transaction and/or market failures. An example of this is in the second-hand car market. The vendor of a car has full knowledge (perfect information) about the car’s history and condition. The potential buyer does not have firsthand knowledge regarding the car’s history or condition and is reliant on information from the seller. The potential buyer may be unable to rely upon the information from the seller, which can frustrate a sale.
Moral hazard – Hidden action
It is the concept that people will take undue risks if others will bear the consequences if things don’t go well. The concept originates from the insurance industry where the insured party may take more risks because they are indemnified against losses.
Moral Hazard is also referred to as a special case of asymmetric information which occurs when one party has more knowledge than the other. It can arise where there is a contract between two parties, the principal and the agent. The principal hires an agent to perform a task because of his/her specialised knowledge. The agent can take advantage of the principal’s lack of knowledge and may intentionally underperform. This is referred to as the principal-agent problem. Moral Hazard refers to the hazard or risk of inappropriate or immoral behaviour by an agent. It is the theory that people may ignore the potential moral implications of their choices; if they can’t be monitored carefully and don’t have to face consequences.
The more one feels that there is no burden of responsibility or consequences for risks taken, the greater the tendency to take risks. For example, you might get full insurance cover on a rental car and may be more likely to engage in wreckless driving such as bouncing over ramps. This is because there are no consequences and it’s not your property.
An example of the principal-agent relationship is between the employer and employee. The employer is the principal and hires the employee, the agent to do a job. Poor monitoring of employees is a breathing ground for moral hazard.
Moral hazards can be overcome by offering incentives, through better monitoring and by penalising inappropriate behaviour. Examples of common incentives are no claims bonuses on insurance premiums, bonuses for hard working staff. Banks penalise loan payment defaults by giving bad credit ratings.
Adverse selection - Hidden Characteristics (information)
Asymmetric information can lead to adverse selection of goods and services. Adverse selection is a problem which arises in markets when one party has more information than the other about a good or service, the less informed party may adversely select as a result.
The health insurance industry is a prime example of where adverse selection occurs. Purchasers of health insurance are much more aware of the state of their health than insurance companies. People with hidden unhealthy habits or illnesses are more likely to purchase health insurance. Insurance companies can adversely select customers if they conceal relevant health information.
Another example would be life insurance, a customer takes up smoking (thus increasing his chance to die) and the insurance company is not aware of this so it undercharges him. This also can be defined as 'Lemons Problem'. Lemons problem was popularized by a 1970 research paper by economist George Akerlof.
Signalling
Signalling is a method used by the informed party to demonstrate the quality of a product, for example, through its price. It’s a solution to problems arising from asymmetric information, signalling is the action taken by an informed party to reveal firsthand information.
An example would be a high price on clothing would signal that it’s of a high quality.
Signalling is a method used by the informed party to demonstrate the quality of a product, for example, through its price. It’s a solution to problems arising from asymmetric information, signalling is the action taken by an informed party to reveal firsthand information.
An example would be a high price on clothing would signal that it’s of a high quality.
Screening
Screening is the action taken by an uninformed party to induce an informed party to disclose information. It is a method of avoiding adverse selection. An example of adverse selection is where a buyer looking for a second hand car requests that their mechanic examine it, if the vendor refuses, this signals that there are potential defects and the buyer may offer a lesser sum or go elsewhere.
Screening is the action taken by an uninformed party to induce an informed party to disclose information. It is a method of avoiding adverse selection. An example of adverse selection is where a buyer looking for a second hand car requests that their mechanic examine it, if the vendor refuses, this signals that there are potential defects and the buyer may offer a lesser sum or go elsewhere.
What do we mean by "Political economics"
We have observed that markets sometimes don't distribute resources in an equal manner. The government may interfere in a market when it is deemed inefficient or inequitable to try and ultimately rectify the situation. Nonetheless, before letting the government intervene, we have to remember that the government itself is also an "imperfect institution". Let me introduce you to the topic of political economy, sometimes called "the field of public choice", that administers the methods of economics to study how government works.
We have observed that markets sometimes don't distribute resources in an equal manner. The government may interfere in a market when it is deemed inefficient or inequitable to try and ultimately rectify the situation. Nonetheless, before letting the government intervene, we have to remember that the government itself is also an "imperfect institution". Let me introduce you to the topic of political economy, sometimes called "the field of public choice", that administers the methods of economics to study how government works.
Condorcet Voting Paradox
For instance, a city is planning to build a shopping centre. One would assume that the planner would decide on the majority choice. However, in reality there will be number of different locations that the shopping centre could be built. The late 18th century French political theorist, the Marquis de Condorcet, noted, that one might run into difficulty if using democracy to choose the outcome.
For example, there are three plots of land, A, B and C, and three voter types with the preferences:
For instance, a city is planning to build a shopping centre. One would assume that the planner would decide on the majority choice. However, in reality there will be number of different locations that the shopping centre could be built. The late 18th century French political theorist, the Marquis de Condorcet, noted, that one might run into difficulty if using democracy to choose the outcome.
For example, there are three plots of land, A, B and C, and three voter types with the preferences:
If the planner were to ask voters to choose between plot B and C, voters 1 and 2 would vote for B and B would be the winning outcome using pairwise voting. He then asks to choose between A and B, voters 1 and 3 would vote for A, giving A the majority. Examining this, the planner may jump to conclusions and decide that if voters prefer B to C and A to B, plot A must be the obvious choice. However, if the planner were to ask the voters to choose between A and C, voters 2 and 3 would vote for C, (i.e. A beats B, B beats C, C beats A). The Condorcet voting paradox shows that the axiom of transitivity may not always be obeyed.
Therefore, two things can be deduced from Condorcet's paradox: One being that deciding on the voting order can have a great impact on the outcome. The other being that a majority voting system, by itself, doesn't tell us what society really wants.
Arrow's Impossibility Theorem
Political theorists have been spending a lot of time and effort studying various voting systems and proposing new ones ever since Condorcet's paradox was produced. Jean-Charles de Borda, an 18th century mathematician and political scientist, as an alternative to pairwise voting, devised the Borda count. This involves the voters ranking the possible outcomes. Each voter would give 1 point for the last place, 2 for the place above that, 3 for the place above that and so on. Using the table above, outcome A would be the winner.
Political theorists are still left wondering: Is there a perfect voting system? 1972 Nobel Prize in Economics winner, Kenneth Arrow, tackled this question in his 1951 book Social Choice and Individual Values. Arrow first assumes that individuals in society have preferences over certain outcomes: A, B, C etc. He then assumes that the voting scheme for society must satisfy several properties:
All of these properties seem desirable. However, Arrow proved, mathematically and incontrovertibly, that no voting system could satisfy all of these properties. This called Arrow's impossibility theorem.
We have already seen this problem in the Condorcet paradox (i.e. transitivity is not sustained). Also, if using the Borda count method and outcome C was removed, it would then be left to just outcome A and B. This results in A winning, showing that the independence and irrelevant alternatives property is not satisfied as the result depends on the number of points A and B get, but also the number of points that C gets, although irrelevant.
Arrow's theory shows that we should not completely disregard democracy completely but whichever voting system we choose, it will be flawed in some way as a mechanism for social choice.
Political theorists have been spending a lot of time and effort studying various voting systems and proposing new ones ever since Condorcet's paradox was produced. Jean-Charles de Borda, an 18th century mathematician and political scientist, as an alternative to pairwise voting, devised the Borda count. This involves the voters ranking the possible outcomes. Each voter would give 1 point for the last place, 2 for the place above that, 3 for the place above that and so on. Using the table above, outcome A would be the winner.
Political theorists are still left wondering: Is there a perfect voting system? 1972 Nobel Prize in Economics winner, Kenneth Arrow, tackled this question in his 1951 book Social Choice and Individual Values. Arrow first assumes that individuals in society have preferences over certain outcomes: A, B, C etc. He then assumes that the voting scheme for society must satisfy several properties:
- Unanimity: If everyone prefers A to B, A should beat B
- Transitivity: If A beats B and B beats C, A should beat C
- Independence of irrelevant alternatives: The ranking between any two outcomes A and B should not depend on whether some third outcome C is available
- No dictators: There is no person that always gets his way, regardless of everyone else's preferences
All of these properties seem desirable. However, Arrow proved, mathematically and incontrovertibly, that no voting system could satisfy all of these properties. This called Arrow's impossibility theorem.
We have already seen this problem in the Condorcet paradox (i.e. transitivity is not sustained). Also, if using the Borda count method and outcome C was removed, it would then be left to just outcome A and B. This results in A winning, showing that the independence and irrelevant alternatives property is not satisfied as the result depends on the number of points A and B get, but also the number of points that C gets, although irrelevant.
Arrow's theory shows that we should not completely disregard democracy completely but whichever voting system we choose, it will be flawed in some way as a mechanism for social choice.
Median Voter Theorem
Most societies use voting, usually by majority rule, as their method of choosing leaders and policies, despite Arrow's theorem. In political economics, we must study how governments run by majority rule work. Who determines what policy or leader is chosen?
For example, a government is deciding how much to spend on a public good, e.g. transport or police. Each voter has their own preferred budget and always prefers outcomes closest to their own budget than outcomes further away. Therefore, we can arrange these voters from those who prefer the smallest budgets to those who prefer the largest.
According to the median voter theorem, majority rule will produce the outcome most preferred by the median voter. The median voter is the middle voter in the arrangement of voters (e.g. the median of 100 voters would be 50). For example, assume the median amount was €10bn, the average was €8bn and the mode was €14bn. The median voter always win as half of all voters want €10bn or more, and half want €10bn or less. If someone were to propose a budget of €6bn, everyone who prefers €10bn or more would vote for the median voter. The same would happen if someone proposed €13bn, as everyone who prefers €10bn or less will vote for the median voter.
Interestingly, Condorcet's paradox does not come into action here. When the voters are picking their point along the line and they choose their own preferred point, the paradox does not apply.
The median voter theorem can been seen when two political parties are trying to increase their chance of election, both parties will move their political positions to the median voter. For example, two parties, Red and Blue, are up for election. The Blue party decides on a budget of €15bn. This makes sense due to the fact that this outcome has the most people voting for it (i.e. the modal choice). However, the Red party declares their budget of €10bn, choosing the median voter, giving them 50% of the vote. If the Blue party wants to win this election, they must move their position closer to the median voter.
Another application of this theorem is that the votes of the minorities are not given a lot of weight in the matter. For example, 30% of voters want to spend a lot of money on building a new road, 70% don't want to spend any money. The median voter will result in no money being spent, regardless of how much the minority want it. This rules out the option of compromise and taking in everyone's preference on the matter. Majority rule only deals with the person directly in the middle.
Most societies use voting, usually by majority rule, as their method of choosing leaders and policies, despite Arrow's theorem. In political economics, we must study how governments run by majority rule work. Who determines what policy or leader is chosen?
For example, a government is deciding how much to spend on a public good, e.g. transport or police. Each voter has their own preferred budget and always prefers outcomes closest to their own budget than outcomes further away. Therefore, we can arrange these voters from those who prefer the smallest budgets to those who prefer the largest.
According to the median voter theorem, majority rule will produce the outcome most preferred by the median voter. The median voter is the middle voter in the arrangement of voters (e.g. the median of 100 voters would be 50). For example, assume the median amount was €10bn, the average was €8bn and the mode was €14bn. The median voter always win as half of all voters want €10bn or more, and half want €10bn or less. If someone were to propose a budget of €6bn, everyone who prefers €10bn or more would vote for the median voter. The same would happen if someone proposed €13bn, as everyone who prefers €10bn or less will vote for the median voter.
Interestingly, Condorcet's paradox does not come into action here. When the voters are picking their point along the line and they choose their own preferred point, the paradox does not apply.
The median voter theorem can been seen when two political parties are trying to increase their chance of election, both parties will move their political positions to the median voter. For example, two parties, Red and Blue, are up for election. The Blue party decides on a budget of €15bn. This makes sense due to the fact that this outcome has the most people voting for it (i.e. the modal choice). However, the Red party declares their budget of €10bn, choosing the median voter, giving them 50% of the vote. If the Blue party wants to win this election, they must move their position closer to the median voter.
Another application of this theorem is that the votes of the minorities are not given a lot of weight in the matter. For example, 30% of voters want to spend a lot of money on building a new road, 70% don't want to spend any money. The median voter will result in no money being spent, regardless of how much the minority want it. This rules out the option of compromise and taking in everyone's preference on the matter. Majority rule only deals with the person directly in the middle.
Politicians are people too
Studying consumer behaviour, economists assume that consumers buy goods/services that give them the most satisfaction. When studying business behaviour, economists assume they produce goods/services that are the most profitable for them to produce.
It would then be understandable to assume that politicians always look out for society, choose policies and make decisions that are most beneficial to everyone, with efficiency and fairness. This is ideal but, realistically, not always the case. The driving force behind most of a political leader's decisions would most likely be self-interest. Some are driven by the opportunity to be re-elected and their goal to stay in power for as long as possible, willing to sacrifice the national interest to maintain their number of voters. Some politicians are simply motivated by greed. This can be seen in some of the world's poorer countries where corruption and greed has devastated the nation as a whole.
This may not be political science, and it would probably be best to leave the analysis of politicians to the political scientists, but we must keep in mind that economic policies are made not by some altruistic ruler, but by real people with human desires. Sometimes politicians are motivated by ambition to help the nation, but sometimes the motivation would be their own personal political and financial goals.
Studying consumer behaviour, economists assume that consumers buy goods/services that give them the most satisfaction. When studying business behaviour, economists assume they produce goods/services that are the most profitable for them to produce.
It would then be understandable to assume that politicians always look out for society, choose policies and make decisions that are most beneficial to everyone, with efficiency and fairness. This is ideal but, realistically, not always the case. The driving force behind most of a political leader's decisions would most likely be self-interest. Some are driven by the opportunity to be re-elected and their goal to stay in power for as long as possible, willing to sacrifice the national interest to maintain their number of voters. Some politicians are simply motivated by greed. This can be seen in some of the world's poorer countries where corruption and greed has devastated the nation as a whole.
This may not be political science, and it would probably be best to leave the analysis of politicians to the political scientists, but we must keep in mind that economic policies are made not by some altruistic ruler, but by real people with human desires. Sometimes politicians are motivated by ambition to help the nation, but sometimes the motivation would be their own personal political and financial goals.
What is behavioural economics?
Behavioural economics is a method of economic analysis that applies psychological insights into human behaviour to explain economic decision-making.
The standard neo-classical economic theory relies on the principle that people are always rational and act in a way that maximizes their individual self-interest eg. Consumers try to maximize utility, managers try to maximize profits. These economic agents are sometimes called homo economicus.
Behavioral economics acknowledges that people are imperfect and don’t always make rational decisions. Human reasoning is imperfect, people’s decisions are strongly affected by emotions.
Herbert Simon suggested humans should be viewed as satisficers rather than rational maximisers. A satisficer chooses an option that is ‘good enough’ but not necessarily the best(optimal) option.
Simon’s coined the term "bounded rationality", which is the concept that human decision-making is limited by the information they have available, the amount of information they can process and time constraints in making decisions.
Behavioural economics is a method of economic analysis that applies psychological insights into human behaviour to explain economic decision-making.
The standard neo-classical economic theory relies on the principle that people are always rational and act in a way that maximizes their individual self-interest eg. Consumers try to maximize utility, managers try to maximize profits. These economic agents are sometimes called homo economicus.
Behavioral economics acknowledges that people are imperfect and don’t always make rational decisions. Human reasoning is imperfect, people’s decisions are strongly affected by emotions.
Herbert Simon suggested humans should be viewed as satisficers rather than rational maximisers. A satisficer chooses an option that is ‘good enough’ but not necessarily the best(optimal) option.
Simon’s coined the term "bounded rationality", which is the concept that human decision-making is limited by the information they have available, the amount of information they can process and time constraints in making decisions.
Common mistakes in human decision- making
1. People are overconfident
a) Gambler’s always expect to win the next hand,
b) students are often overconfident about how much study we will accomplish in one evening
2. People attach to much weight to a small number of vivid observations
3. People are reluctant to change their minds, for example: People rarely changes banks or political parties and are slow to uptake cheaper generic medications.
4. People often cherry pick information to re-affirm beliefs their existing beliefs.
5. People often make quick decisions based on rules of thumb and approximation (guessing, gut feeling, intuition, previous experiences) , this is known as Heuristics
1. People are overconfident
a) Gambler’s always expect to win the next hand,
b) students are often overconfident about how much study we will accomplish in one evening
2. People attach to much weight to a small number of vivid observations
3. People are reluctant to change their minds, for example: People rarely changes banks or political parties and are slow to uptake cheaper generic medications.
4. People often cherry pick information to re-affirm beliefs their existing beliefs.
5. People often make quick decisions based on rules of thumb and approximation (guessing, gut feeling, intuition, previous experiences) , this is known as Heuristics
Heuristics
There are three main heuristics
1. Anchoring; people often use their existing knowledge as an ‘anchor’ or starting point for making decisions.
2. Availability; ‘a mental shortcut that occurs when people make judgments about the probability of events by how easy it is to think of examples’ and that ease is contributed to by current events/ media attention.
3. Representatives; People tend to make judgments by comparing how representative something is to an image or stereotype that they hold
Eg. In Ireland, the perception that higher earners don’t bear a fair share of the tax burden is a misconception because this 1% of the work force (200k+) accounted for 25% of the total tax take in 2010.
People Care About Fairness People’s choices are sometimes influenced more by their sense of fairness than self-interest. However the opposite can also be true, people can completely ignore general conceptions of fairness and act based on self interest. Conventional economic theory assumes people are rational wealth maximisers, the ultimatum game theory is an example where human decisions aren't necessarily rational and where pride and other emotions can influence choices.
There are three main heuristics
1. Anchoring; people often use their existing knowledge as an ‘anchor’ or starting point for making decisions.
2. Availability; ‘a mental shortcut that occurs when people make judgments about the probability of events by how easy it is to think of examples’ and that ease is contributed to by current events/ media attention.
3. Representatives; People tend to make judgments by comparing how representative something is to an image or stereotype that they hold
Eg. In Ireland, the perception that higher earners don’t bear a fair share of the tax burden is a misconception because this 1% of the work force (200k+) accounted for 25% of the total tax take in 2010.
People Care About Fairness People’s choices are sometimes influenced more by their sense of fairness than self-interest. However the opposite can also be true, people can completely ignore general conceptions of fairness and act based on self interest. Conventional economic theory assumes people are rational wealth maximisers, the ultimatum game theory is an example where human decisions aren't necessarily rational and where pride and other emotions can influence choices.
Policy makers and employers must consider what the public think is fair when making decisions. Eg. The government in the 2014 budget attempted to demonstrate fairness in reducing availability of medical cards by introducing free GP care to under 5’s.
People Are Inconsistent Over Time
People often prefer instant gratification over long term rewards, and therefore make decisions that are not always in their best interest eg. spending money you had intended to save because you want to buy something now. These choices are not rational and do not maximize overall gain. A person with time inconsistent preferences values the present more than the future.
Interesting and witty Tedtalk with Dan Ariely on behavioural economics
People often prefer instant gratification over long term rewards, and therefore make decisions that are not always in their best interest eg. spending money you had intended to save because you want to buy something now. These choices are not rational and do not maximize overall gain. A person with time inconsistent preferences values the present more than the future.
Interesting and witty Tedtalk with Dan Ariely on behavioural economics