Question

Each of the following is an example of (or would lead to) a particular type of market failure arising from information asymmetry. Identify the type of market failure and justify your answer briefly. a. A woman in the "dating market" complains, "All the good ones are taken." b. A college announces a new policy: Any senior with a GPA less than 2.0 will, upon graduation, have all grades of \(\mathrm{C}-\) or lower retroactively raised to a grade of \(\mathrm{C}\). c. A restaurant in New York hires workers to pass out fliers to pedestrians all over the city, and pays them based on how many fliers are gone (and presumably distributed) when the workers return at the end of the day.

Short answer

a. 'Adverse selection' - Quality potential partners ('good ones') are taken, leaving behind low-quality partners. b. 'Moral hazard' - Students would perform poorly knowing their grades will be raised, lowering the quality of education at the institute. c. 'Principal-agent problem' - Workers could dispose of the fliers without distributing them because they are paid based on the absence of the fliers, causing ineffective distribution of the restaurant's fliers.

Step-by-step solution

Identify Information Asymmetry in 'Dating Market'

In this situation, 'the dating market' is compared to an actual market where goods (potential partners) can be chosen. The woman complaining 'All the good ones are taken' suggests that she believes there is a lack of 'quality' potential partners available to her. This describes a situation of 'adverse selection', which is a market situation where buyers and sellers have different information. Here, 'good ones' (high-quality partners) have already been taken, leaving behind the 'bad ones' (low-quality partners).

Analyze College Grade Change Policy

This college policy would raise any grade lower than C to a C for any senior with a GPA less than 2.0. This policy can lead to 'moral hazard', another market failure situation where one person takes on more risk because someone else bears the burden of those risks. A student would be more likely to perform poorly knowing their grades would be raised, thus lowering the quality of education at the institute. This happens because the policy shields the student from the consequences of failing or not studying, as all of their grades will be raised to a grade of C.

Understand Flier Distribution Policy

In the restaurant example, workers are paid based on how many fliers are gone when they return at the end of the day. This leads to 'principal-agent problem', a conflict arising when a person or entity (agent) is able to make decisions and/or take actions on behalf of, or that impact, another person or entity (the principal). In this case, the workers (agents) could easily dispose of the fliers without distributing them as they are paid based on the absence, not the effective distribution of the fliers. Hence, the restaurant owner (principal) has no easy way to ascertain the optimal distribution of its fliers, leading to a potential market failure.

Key concepts

Adverse Selection

When we talk about adverse selection, we're focusing on a scenario where the seller knows more about the product than the buyer, or vice versa; essentially, it's an imbalance of information. Think of it like heading to a garage sale and eyeing a vintage camera. You might have no clue if it's a rare gem or just another piece to collect dust on your shelf, while the seller might be aware of its value or hidden defects.

In the 'dating market', adverse selection is humorously depicted by the lament, 'All the good ones are taken.' Imagine stepping into a party where, unknown to you, all the charming and compatible people have already paired up, leaving you with fewer desirable choices. Just like in a real market, 'good' partners (high-quality goods) are snatched up quickly, often leaving a 'residue' of less desirable options. The difficulty is you don't have a 'product history report' on your potential partners – if you did, the dating scene might be a lot less hit-and-miss.

To manage adverse selection, markets often evolve mechanisms, such as guarantees or certifications, that help to level the informational playing field. However, in aspects like dating, it's trickier – hence, it remains a whimsical example of how adverse selection plays out in everyday life.

Moral Hazard

Now, let's pivot to moral hazard. This concept occurs when one party can take risks without facing the full consequences of their actions. In the context of insurance, think of someone who's bought a complete auto insurance package; they might be less cautious while driving because they know the insurer will cover any mishaps.

The college's policy to raise grades is a classic example of moral hazard. By ensuring that all grades for seniors below a C will be bumped up, students might slack off, knowing they won't 'fail'. The policy inadvertently encourages lackluster effort, as the college becomes an 'insurer' against bad grades. Students might embrace riskier academic behavior, skipping studies for a game night, because the policy absorbs the fallout of their actions.

This happens when people are shielded from the repercussions that would normally encourage them to act responsibly. Overcoming moral hazard often requires policies that ensure individuals bear a greater share of the risk, thus realigning their incentives with those affected by their decisions.

Principal-Agent Problem

The principal-agent problem can be a real headache in any business relationship. It's all about trust and accountability. Basically, when someone (the agent) is given the responsibility to act on behalf of another (the principal), but their interests don't align neatly, that's where the trouble begins.

In our New York restaurant example, the workers are supposed to distribute fliers, but since they're evaluated by how many fliers they return with, they might just toss them to collect their pay – a quick fix with no real regard for the restaurant's promotional efforts. The owners (principals) are banking on their staff (agents) to operate in the restaurant's best interest, but without a mechanism to track the workers' actions, the trust system breaks down.

To tackle these issues, companies need oversight tools such as performance metrics that align the interests of the agent with the principal, or deterrents against misbehavior. Otherwise, this misalignment can lead to ineffective business operations and can tarnish the reputation of an establishment, illustrating the real-world significance of the principal-agent problem.