Page 585 - The Principle of Economics

equilibrium wage of $2 and hiring Ted. It can offer $10 per hour, inducing both Bill and Ted to apply for the job. By choosing randomly between these two applicants and turning the other away, the firm has a fifty-fifty chance of hiring the compe- tent one. By contrast, if the firm offers any lower wage, it is sure to hire the incom- petent worker.
FYI In many situations in life, in-
Similarly, the worker-effort variant of efficiency-wage theory illustrates a general phenomenon called moral haz- ard. Moral hazard arises when one person, called the agent, is performing some task on behalf of another person, called the principal. Because the principal cannot perfectly monitor the agent’s behavior, the agent tends to undertake less ef- fort than the principal considers desirable. The term moral hazard refers to the risk of dishonest or otherwise inappro- priate behavior by the agent. In such a situation, the princi- pal tries various ways to encourage the agent to act more responsibly.
In an employment relationship, the firm is the principal and the worker is the agent. The moral-hazard problem is the temptation of imperfectly monitored workers to shirk their responsibilities. According to the worker-effort variant of ef ficiency-wage theor y, the principal can encourage the agent not to shirk by paying a wage above the equilibrium level because then the agent has more to lose if caught shirking. In this way, high wages reduce the problem of moral hazard.
Moral hazard arises in many other situations. Here are some examples:
N A homeowner with fire insurance buys too few fire ex- tinguishers. The reason is that the homeowner bears the cost of the extinguisher while the insurance com- pany receives much of the benefit.
N A babysitter allows children to watch more television than the parents of the children prefer. The reason is that more educational activities require more energy from the babysitter, even though they are beneficial for the children.
N A family lives near a river with a high risk of flooding. The reason it continues to live there is that the family enjoys the scenic views, and the government will bear part of the cost when it provides disaster relief after a flood.
Can you identify the principal and the agent in each of these three situations? How do you think the principal in each case might solve the problem of moral hazard?
The Economics of Asymmetric Information
formation is asymmetric: One person in a transaction knows more about what is going on than the other person. This possibility raises a variety of interesting problems for eco- nomic theor y. Some of these problems were highlighted in our description of the theor y of efficiency wages. These prob- lems, however, go beyond the study of unemployment.
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The worker-quality variant of ef ficiency-wage theor y illus- trates a general principle called adverse selection. Adverse selection arises when one person knows more about the at- tributes of a good than another and, as a result, the unin- formed person runs the risk of being sold a good of low quality. In the case of worker quality, for instance, workers have better information about their own abilities than firms do. When a firm cuts the wage it pays, the selection of work-
ers changes in a way that is adverse to the firm.
Adverse selection arises in many other circumstances.
Here are two examples:
N Sellers of used cars know their vehicles’ defects, whereas buyers often do not. Because owners of the worst cars are more likely to sell them than are the owners of the best cars, buyers are correctly apprehen- sive about getting a “lemon.” As a result, many people avoid buying cars in the used car market.
N Buyers of health insurance know more about their own health problems than do insurance companies. Be- cause people with greater hidden health problems are more likely to buy health insurance than are other peo- ple, the price of health insurance reflects the costs of a sicker-than-average person. As a result, people with av- erage health problems are discouraged by the high price from buying health insurance.
In each case, the market for the product—used cars or health insurance—does not work as well as it might be- cause of the problem of adverse selection.