Private Information - I Know Something You Don’t Know

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I've got some really important advice for anyone who's ever
dreamed of opening it All you can Eat buffet. Don't
try this in a college town with a big football team.
Yeah, that would be a bad idea.
Yeah.
I try to avoid All you can Eat buffets because
I can never eat enough food to make it worth it.
You're proving my point, Naz. The football team at the
University of Michigan can put away buckets of food in
the sitting and definitely more than disc jockeys like you,
So that you think at All you can Eat restaurant
is a great deal, and you think it's a bad deal.
And that's the problem. And All you can Eat buffet
is going to attract a lot of football players, and
so you'll get very few people like you, nas with
light appetites that's going to raise the buffet's costs, forcing
them to raise their prices, and that could make things
worse because then light eaters really don't want to go
because the buffet is going to be kind of expensive,
and so the only people think it's worth going would
be football players and other people with big appetites.
You might think, why not just charge those people with
big appetites more, But the problem is that, well, you
know how much you'll eat, the restaurant doesn't.
Your appetite is private information. Private information causes a lot
of problems, and it's our topic today on Think Like
an Economist. I'm Betsy Stevenson.
And I'm Justin Wolfers. We're teaching you the supercharged super
tools of eatomics to help transform your decision making, from
whether to open a buffet restaurant to figuring out the
right type of health insurance for you. Nestre En Tabacoli
fowers with us.
So I can imagine three ways in which private information
could arise. First, it could be that buyers know more
than sellers, such as when restaurant customers know more about
how much they're going to eat. Or possibly sellers might
know more than buyers. Perhaps about the quality of what
they're selling. And finally, sometimes your actions are hidden and
so their private information.
Yeah, and we'll deal with each of those in turn.
In each case, though, we'll see that when I'm worried
that you know something I don't, or you're worried that
I might know something that you don't, it creates a
fog of mistrust, and that mistrust makes it hard for
us to do business together.
So first off, we're going to look at what happens
when sellers know something that buyers don't.
If sellers know something about the quality of the goods
they're selling that buyers don't know or can't easily find out,
they might be tempted to power off some shoddy goods.
That doesn't just impact you, it impacts everybody.
The classic examples the market for used cars. Say I'm
selling my car and I don't know how well it runs.
Maybe it's a bit of a dud or what people
call a lemon, and it takes ages to get going
on a snowy day, or the brakes aren't great on
wet roads. You'd need to have spent many hours driving
this car to know all these quirks. And if I
was honest about all these problems. Well, that would put
you off from buying this car from me, Naz, So
I could just I could just not tell you.
Well, that sounds pretty unfair for me.
It is, but there's really no way of your learning
about these problems after a quick test drive. And there's
a big incentive for me not to tell you either.
If you don't know about the problems, you're going to
be willing to pay more for the car than if
I'd been honest.
Justin's lack of transparency isn't just bad for you, Naz,
it's bad for the whole market for cars. It's pretty
common for people to sell used cars, which are lemons,
and when there are so many lemons in the market, well,
buyers come to expect that a lot of used cars
are lemons. So imagine that I'm selling my car, but
unlike Justin's car, my car has no problems and is
running great. But used cars now have a bad reputation
due to sellers like Justin, So buyers they're just not
going to be as willing to pay as much for
my car or used cars in general, as they otherwise would.
Does this mean you're not gonna get much money for.
Your car exactly. In fact, it may not even be
worth me selling my car at all. Given the low price,
buyers are going to be willing to pay me for it.
And this is what happens in the market for used cars.
You end up with a lot of lemons because people
like me with well maintained cars can't get enough money
for selling their cars, so they just hang on to
them or give them to somebody in their family.
We call this the adverse selection of sellers. When people
selling something have more information about its quality than people
buying it, it's likely we'll end up with a lot
of low equality goods on the market. We call it
adverse selection because when sillas know more about the quality
of what they're selling in buyers, then they may sell
bad or adverse goods. They're more likely to sell lemons.
There must be things that sellers of high quality goods
can do, though, Betsy, Could you provide a warranty or
maybe some kind of certificate from a mechanic which states
that the car is running well.
Yes, and warranties in particular are especially helpful. Someone is
selling a lemon, wouldn't want to offer a warranty and
so offering a warranty confirms that I'm selling a high
quality car, and that will make people more willing to
pay a fair price for it. I can now charge
more for my car as I've effectively signaled that my
car is worth this higher price.
Basically, the buyer needs to learn what the seller knows,
which is whether or not they're buying a lemon.
Yes, And you'll see this in all sorts of ways.
With some products, the government actually forces businesses to provide
truthful information about the quality of what they're selling. For instance,
in the US, medicines need to have a label that
says they're cleared by the Food and Drug Administration, and
so if you buy medicine with this label, then it
contains the staff that the label tells you it contains.
You also see that fruits sometimes have stickers that say
they're organic. Again, not everyone can stick these on their fruit. Actually,
organic farmers fought pretty hard to be able to get
these stickers from the Department of Agriculture that confirms that
their fruit is organic, so that they can sell them
at that higher premium for organic fruit.
So when buyers don't have information about the quality of
a product, sellers can do things to confirm the quality
of their products. They could provide a warranty when selling
a used car, or get a confirmation of quality from
the government.
Yes, and there's another way. Sellers can also get a
third party service to verify the quality of what they're selling.
Let's go back to used cars. There's a website called Carfax,
which collects a lot of data about a car's ownership history,
such as if it's been in an accident or any
maintenance records.
Another way, you'll see third parties confirm qualities through reviews
of products and services on all sorts of websites. I
don't know the quality of a food at a restaurant
before I sit down for a meal, but if it
serves pretty dodgy food, I'll read about it and Yelps reviews.
The same thing goes with reviews on Amazon. Potential customers
can find out from other people what quality to expect
from a certain business.
Now we're going to look at what happens when buyers
have more information than sellers. But to start, what kind
of information are we talking about.
We're talking about information about what kind of buyer you are.
I'm going to make another recommendation to our listeners. You
should never open a business offering insurance against divorce.
Why would you do that anyway?
Divorce is really stressful and it's expensive. A couple splitting up,
well now need two homes and they can't share and
split all sorts of expenses, and divorce lawyers cost a
lot too. Divorce actually puts a lot of families at
risk of poverty.
So you'd think insurance against divorce would be really helpful.
But think about it, who's going to buy it?
So this is insurance against divorce. This means if you
end up getting divorced, the insurance company pays you something.
So I guess divorce insurance is good for people who
think they're going to need this payout. So I guess
people who think they're going to be getting divorced exactly.
People in stable marriages aren't going to consider getting insurance
against divorce. Why payout money for insurance you probably won't need.
But if your marriage is on the rocks and you
think you'll be getting divorced sometime soon, well it makes
a lot of sense to take out insurance against divorce.
So the only people who are going to buy this
type of insurance are the sorts of people who will
need it and are therefore likely to get payouts exactly.
This sort of insurance company will end up making a
heck of a lot of payments.
This is an example of adverse selection of buyers. The
problem is that if you don't know what kind of
customers you're getting, you'll probably get customers you don't want.
So if most of your customers are heading for divorce,
then you're gonna have to make a lot of payouts,
and that means you're gonna have to charge even more
for this insurance to cover those costs. People in stable
marriage has already had very little incentive to take you
out this insurance, and at a higher price, they'll have
even lessons and if to buy it.
When buyers have more information about themselves and their circumstances
than sellers, you'll end up having high cost buyers interested
in a product that's going to push the price up more.
It's actually a problem in the insurance market in general
that high risk people like insurance the most.
Yeah, and I'm wondering does this happen in health insurance.
It's exactly what I was thinking about. You know, just
as people who are headed for divorce are more likely
to buy divorce insurance. You know, people who have poor
health and risk big medical bills are going to be
more willing to buy expensive health insurance.
And so the problem when companies off a health insurance
is that the customers they get aren't the low cost
customers they want. They'll be getting a lot of older
people in ill health rather than younger and healthier people.
It's a real dilemma for a health insurance company because
if their customers are unhealthy, they're going to pay out
a lot in medical bills. This will force them to
raise their prices, which will push more healthy people to
opt out of insurance, and how'll drive their prices up
even higher. It can make offering health insurance so unprofitable
that no one will want to offer it.
That's why in countries like Australia or the UK, as
the government provides health insurance, which effectively forces everyone to
buy it. In the United States, Obamacare used to require
to buy insurance or face a fine, and the government
subsidizes your insurance in the US, so you might buy
it even if you're healthy. It's all about trying to
make health insurance attractive for everyone, not just unhealthy folks.
When buyers know something that sellers don't. Are there other
ways to fix this problem? I mean, could sellers find
out more about buyers?
Yes, And the government helps the insurance industry out because
this is such a big problem. Governments make it illegal
for you to lie to on an insurance company. It's
called insurance fraud. So one of the health insurer asks
if you're a smoker, If you're caught lying, you'll get
a criminal record. That can be enough of an incentive
for people to be honest when filling out their insurance forms.
Businesses can also do clever things to get customers to
reveal a bit more about themselves, not just asking them questions.
One strategy is a seller might charge a high deductible
for an insurance policy. Let's say you're buying auto insurance
and you get offered a policy with a three thousand
dollars deductible. Is that a policy you might consider?
Naz, Yeah, So I try to be a careful driver.
So if the deductible is three thousand dollars, well it's
unlikely I'm going to get into an accident and I'm
going to actually end up paying that so yeah, I'll
still buy that insurance.
Exactly, So, a careful driver like you is more likely
to buy a policy with a high deductible. Now let's
take Justin. Justin's actually a terrible driver.
That's true, I'm awful.
So Justin, would you buy this policy with a three
thousand dollar deductible?
No way. The truth is I'm gonna get into an
accident and I don't want to have to pay three
thousand dollars. Look, I'd be willing to pay a little
bit more for an insurance policy where I only had
to pay one hundred dollars deductible for each time I crashed.
Right, So having a high deductible is a way to
weed out high risk drivers like Justin and attract those
low risk customers like Naz.
The final factor we're looking at as we learn about
private information is the problem of hidden actions. This sounds
a little different to the previous two problems we've just
gone through.
It is when businesses are sellers have more information about
their product, or when customers know more about themselves or
how costly they will be for a business. We're talking
about hidden types. Our dodgy used car salesman telling you
a piece of junk. It's a hidden type. In this
final section of the episode on private information, to focus
on actions, specifically hidden actions.
When we say hidden actions, we don't mean that you're
being shifty, well not necessarily, but that your actions can't
be easily observed.
Speaking of shifty justin economists do call these actions moral hazard,
and they can be a big problem. Just go back
to insurance, which protects you again something bad happening, But
having insurance can also change your behavior. Let's say you
bought travel insurance before your next big trip. Now that
you know someone else is gonna pay all the medical bills,
you might think it's worth trying out skydiving after all.
The problem with actions that are moral hazard is that
when your actions are hidden, you might behave differently. So
say you take out car insurance, NEZ, the insurance company
doesn't know if you're going to be driving with care
or you'll be driving dangerously. They can't observe that.
You know, if I have insurance, maybe I'll be a
little more reckless. Who knows, that's right.
So your type now this is you're a careful driver,
but now that you have insurance, you might throw caution
into the wind hang on.
This sounds like a catch twenty two.
Well, this is the problem with moral hazard. It's actions
that are hidden. Once you insure against a bad thing,
it's more likely that the bad thing will happen.
So when someone takes out travel insurance for extreme sports,
for example, it's more likely they're going to be more
reckless and end up needing that insurance payout. Exactly, insurance
companies must have come up with ways to protect against
moral hazard.
There are some things businesses can do. First off, you
can require these hidden actions to become well observable. Let's
look at car insurance. The cost for your insurance depends
on a bunch of factors, including if you've made claims
in the past year. So being a careful driver helps
you to pay less for car insurance next year. And increasingly,
car insurance companies are actually asking customers if they can
monitor their driving through an app on their phone or
a camera in their car.
This sounds pretty invasive.
It is, but it allows to collect data showing if
you're driving carefully or not, and if you're driving carefully,
they may offer you cheaper car insurance next year. They
can now observe your actions and more accurately target insurance
to you.
They can go one step further and even help you
become a safer driver by offering discounts on courses that
help you drive more safely.
Another thing that can reduce the moral hazard problem is
to give your skin in the game. With a lot
of types of insurance, there's a deductible, an amount you
have to pay before you can claim the rest of
your costs. Having that deductible gives you an incentive to
not have to claim insurance.
And let's say I did buy that car insurance with
a deductible of three thousand dollars on any claim I make.
How does this get around to moral hazard?
If you have to pay the first three thousand dollars
of any claim, that's an incentive for you not to
make claims unless you really need to. It's an incentive
to drive more safely.
The government can also ban certain behaviors. For instance, laws
that prevent speeding help prevent the moral hazard that people
with insurance might drive too fast. If you face a
fine for driving too fast, then well, now you face
a strong deterrent that will lead you to drive more safely,
making you less likely to make an insurance claim.
Let me try to summarize with private information, it's all
about when I know something you don't know, or you
know something I don't know.
Yep, that's the problem of private information. Basically, if you
know something I don't, I've got a good reason to
mistrust you. And if I know something you don't, you've
got a good reason to mistrust me. The fog of
mistrust can make it hard for us to do business together.
When sellers know something buyers don't, we can get the
lemons problem. If you can't tell if you're buying a
high quality product or a lemon, then you won't pay
more for a quality car. So folks with good cars
or good products are going to be less likely to
sell them. And if most of the products being offered
for sale lemons, then buyers are less interested.
And when buyers know something that sellers don't, say there
are high or low cost buyer then sellers can't tailor
their prices to different groups. That all you can eat
buffet is going to attract exactly the customers you don't want,
Like the Michigan football team, the customers you get aren't
the customers you want. And this is a big deal
for insurance companies because health insurance is most attractive to
sick people, travel insurance is most attractive for skydivers, and
divorce insurance is most attractive for philanderers.
These are all problems that arise when the type of
buyer or sealery is unclear, and it's called adverse selection.
But similar problems arise when the actions you take aren't observed.
Moral hazard refers to these actions you take, like speeding
because you think you won't get caught and you won't
bear the consequences of your actions.
And is there anything you want our listeners to think
about over the next few days.
Well, in each of your interactions over the next few days,
I want you to think about how important information is
and whether the other person might know something that you.
Don't, and think about what you know that they don't.
And it's those asymmetries that can undermine trust between you.
Of course, your real goal is to find creative ways
to restore the trust.
Betsy Justin, thank you for digging into the problem of
private information.
Today and has hopefully this episode helped solve a private
information problem. At the start of today, I knew about
moral hazard in advist selection and you didn't.
So we've solved that information problem. Now you and our
listeners just need to go out there and tackle the
other information problems that you face as you go about
your daily life. To get the most out of this show,
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