12

INFORMATION AND BEHAVIOURAL

ECONOMICS

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Principal And Agent
The two parties to an economic decision can be referred
to as principal and agent.
◦ The principal is a person for whom another person, called
the agent, is performing some act.
◦ The agent is a person who is performing an act for
another person, called the principal.
The principal cannot always be sure that the interests of
the agent are sufficiently aligned with the interests of the
principal.
◦ At the heart of the principal-agent problem is asymmetric
information.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Asymmetric Information
A difference in access to relevant knowledge is
called information asymmetry.
Asymmetric information is where two parties have
access to different information.
◦ A worker knows more than his employer about his
work effort. This is an example of a hidden action.
◦ A seller of a used car knows more than the buyer
about the car's condition. This is an example of a
hidden characteristic.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Hidden Actions and Moral
Hazard
Moral hazard refers to the tendency of a person
who is imperfectly monitored to engage in
dishonest or otherwise undesirable behaviour.
◦ Workers (agents) may be tempted to shirk their
work-related responsibilities…
◦ … because their employers (the principals) do not monitor their
behaviour closely.
◦ Employers can respond by:
◦ Better monitoring - High wages - Delayed payment.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Hidden Actions and Moral
Hazard
Adverse selection is where a principal knows more
about their situation than the agent leading to the
agent preferring not to do business with the
principal.
• Insurance company needs to distinguish between its
high-risk and low-risk customers.
• Some investment banks hide the full extent of the risk of
certain investments sold to their clients.
• Regulations are put in place to address the problems e.g.
fit smoke alarms or face higher premiums - no claims
bonus –restrict building on flood plains.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Hidden Characteristics: Adverse
Selection and the Lemons Problem
The market for cars
◦ In the used car market, cars can be classified as
oranges (good cars) or lemons (bad cars).
◦ Only the seller knows if it is an orange or lemon.
◦ The buyer will not wish to pay a high price if there is
a risk of buying a lemon.
◦ Maybe most cars are lemons, otherwise why sell
good car.
◦ Therefore many people avoid buying vehicles in the used
car market

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Hidden Characteristics: Adverse
Selection and the Lemons Problem
The labour market workers should know their
abilities better than their employers.
◦ When a firm cuts wages the more talented workers
are more likely to quit, knowing they are better able
to find other employment.
◦ If the firm keeps wage levels as they are and lays off
workers, then part of those selected for redundancy
may be the more talented, but the firm will still be left
with some of the talented workers.
◦ In the labour market, wages may be stuck at a level
above the equilibrium wage, resulting in
unemployment.
FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS
2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Hidden Characteristics: Adverse
Selection and the Lemons Problem
The insurance market
◦ In insurance markets, buyers with low risk may
decline to purchase insurance because the price is
too high.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Signalling to Convey Private
Information
Signalling
◦ Signalling refers to an action taken by an informed
party to reveal private information to an uninformed
party.
◦ Advertising is an example – it’s worth advertising a good product
because it will generate repeat business. Advertising a poor product
may generate one-off purchases but won’t be as cost effective.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Screening to Induce
Information Revelation
Screening
◦ Screening is an action taken by an uniformed party
which induces an informed party to reveal
information.
◦ An example is the use of deductibles by insurers to induce motorists
to reveal their own judgments about their riskiness.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Asymmetric Information and
Public Policy
When some people know more than others do,
the market may fail to put resources to their best
uses.
Although asymmetric information may call for
government action, three facts complicate the
issue:
◦ Private markets can sometimes deal with information
asymmetries on their own
◦ The government rarely has more information than the
private parties.
◦ The government itself is an imperfect institution.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Deviations From The Standard
Economic Model
Recently, a field called behavioural economics
has emerged in which economists make use of
basic psychological insights to examine
economic problems.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
People Aren’t Always Rational
Economists assume that human beings are
always rational.
◦ Firm managers maximise profit.
◦ Consumers maximise utility.
◦ Given constraints that they face, these individuals make
decisions by rationally weighing all costs and benefits .
Real people are more complex.
◦ People can be forgetful, impulsive, confused, emotional,
and short-sighted.
◦ They are “satisficers”.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
People Aren’t Always
Rational
◦ Mental accounting is when people attach a subjective
value to parts of their budgeting.
◦ Herd mentality takes place when following what
others are doing since the herd can’t be wrong.
◦ Prospect theory suggests people attach different
values to gains and losses and do so in relation to
some reference point.
◦ The endowment effect is where the value placed on
something owned is greater than on an identical item
not owned.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
People Care About Fairness
The ultimatum game
◦ Two volunteers are to play a game and could win a total of
R100.
◦ Player A’s job must propose a division of the prize between
himself and the other player.
◦ Player B decides whether to accept or reject it.
◦ If Player B accepts the proposal, both players are paid
according to the proposal. If Player B rejects the proposal,
both players receive nothing.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
People Care About Fairness
Conventional economic theory and the ultimatum game.
◦ Player A should know that if he offers R1 to Player B and keeps
R99 for himself, Player B should accept it.
◦ R1 is greater than R0 so Player B is still better off than not
accepting the proposal.
Reality and fairness.
◦ Such a paltry offer would often be rejected by Player B.
◦ Knowing this, Player A should offer a more substantial portion of
the money to Player B.
◦ People maybe driven by a sense of fairness.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
People Are Inconsistent Over
Time
Would you prefer (A) to spend 50 minutes doing a
boring task immediately or (B) to spend 60 minutes
doing the task tomorrow?
◦ Many people choose B to put it off for another day.

Would you prefer (A) to spend 50 minutes doing the

task in 90 days or (B) to spend 60 minutes doing the
task in 91 days?
◦ Many people will now choose A to minimise the time spent
on the task.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
People Are Inconsistent Over
Time
People often make plans for themselves but then fail
to follow through.
The desire for instant gratification can induce the
decision-maker to abandon his past plan.
An important implication is that people should try to
find ways to commit their future selves to following
through on their plans.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Summary
o In many economic transactions, information is
asymmetric.
o When there are hidden actions, principals may be
concerned that agents suffer from the problem of
moral hazard.
o When there are hidden characteristics, buyers may
be concerned about the problems of adverse
selection among sellers.
o Private markets sometimes deal with asymmetric
information with signalling and screening.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Summary
o The study of psychology and economics reveals
that human decision-making is more complex than
assumed in conventional economic theory.
o Systematic mistakes that people make include
mental accounting and herd mentality.
o Prospect theory suggests people attach different
values to gains and losses and do so in relation to
some reference point. The endowment effect is
when the value placed on something owned is
greater than on an identical item not owned.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018
Summary
o People are not always rational, they care
about the fairness of economic outcomes,
and they can be inconsistent over time.

FOR USE WITH MANKIW / TAYLOR / NCWADI, MICROECONOMICS

2ND SA EDITION 9781473763463 © CENGAGE EMEA 2018