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- [Tyler] Previously, we discussed asymmetric information
and how that can cause adverse selection in markets.
In this video, we'll tackle how asymmetric information
can lead to moral hazard.
Let's start with an example.
Imagine you're buying a bottle of water.
You probably have a pretty good idea
of what you're getting, H2O, especially if you've bought
the same brand of water before.
The information that the seller and the buyer have
is pretty close to equal.
But things get more complicated if you're dealing
with something like repairing your car.
The mechanics says you need a Johnson rod.
Do you? Do you even know what a Johnson rod is?
The mechanic knows a lot more about car repair than you do,
and that makes it hard to know whether the mechanic is correct
or even telling the truth.
You might end up paying a lot of money for car repairs
you don't really need.
This is another example of asymmetric information
where one party to an exchange has more or better information
than the other party has.
As we'll see, asymmetric information can challenge markets
and sometimes cause them to fail.
When one party to an exchange has an information advantage,
they may have an incentive to use that advantage
to exploit the other party, and that temptation to exploit
is called moral hazard.
The car repair problem is just one example
of asymmetric information and moral hazard.
A taxi driver has more information about the roads
than does a tourist.
He may take a longer route in order to get a higher fare.
A restaurant owner knows more about the safety of his restaurant
than does his insurance company.
He might choose to skimp on sprinklers
if he's got fire insurance.
An employee knows what he's been working on all day
whereas the manager maybe does not.
The employee might choose to goof off rather than do his job.
These examples highlight a concept called the principal-agent problem.
Often when you hire someone, that person has more information
than you do.
Indeed, that's often why you pay to hire them.
In the case of your car, you are the principal
and the mechanic is your agent.
Your incentive is to get your car fixed
and not waste too much money.
His incentive might be to get as much money
out of you as possible.
Given that he has information about cars that you don't,
he can lie to charge more.
In this case there are conflicting incentives,
and you don't have the information to know
a good deal from a bad deal.
Ideally, you would like to align the incentives
of the mechanic with yours, so you don't get swindled.
That is at least, in principle, how you can solve
a principal-agent problem.
No one likes to be ripped off, but the problem of moral hazard
runs deeper than just the rip-off.
The bigger problem is that the potential for a rip-off
means that a transaction maybe less likely to occur
in the first place.
If you know the mechanic may recommend more service
than is necessary, you might, for instance,
pass on some recommended precautionary repairs
and just wait until your car breaks down.
Of course, that can be inefficient.
You’d prefer to perform that preventive maintenance
and not break down unexpectedly.
But because of asymmetric information,
you can't trust your agent, the mechanic,
and so you pass on those repairs for fear of being ripped-off.
So we can see that asymmetric information can impede trade
and limit the great benefits of specialization through markets.
So what can we do?
Well, take a moment to think about this,
and perhaps you can anticipate some of the solutions
we'll discuss in the next video.
- [Narrator] If you want to test yourself,
click “Practice Questions.”
Or, if you're ready to move on, just click “Next Video.”
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