WEBVTT

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- [Tyler] Previously, we discussed
asymmetric information

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and how that can cause
adverse selection in markets.

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In this video, we'll tackle
how asymmetric information

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can lead to moral hazard.

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Let's start with an example.

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Imagine you're buying
a bottle of water.

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You probably have
a pretty good idea

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of what you're getting, H2O,
especially if you've bought

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the same brand of water before.

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The information that the seller
and the buyer have

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is pretty close to equal.

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But things get more complicated
if you're dealing

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with something
like repairing your car.

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The mechanics says you need
a Johnson rod.

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Do you? Do you even know
what a Johnson rod is?

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The mechanic knows a lot more
about car repair than you do,

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and that makes it hard to know
whether the mechanic is correct

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or even telling the truth.

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You might end up paying
a lot of money for car repairs

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you don't really need.

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This is another example
of asymmetric information

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where one party to an exchange
has more or better information

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than the other party has.

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As we'll see, asymmetric
information can challenge markets

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and sometimes cause them to fail.

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When one party to an exchange
has an information advantage,

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they may have an incentive
to use that advantage

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to exploit the other party,
and that temptation to exploit

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is called moral hazard.

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The car repair problem
is just one example

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of asymmetric information
and moral hazard.

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A taxi driver has more information
about the roads

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than does a tourist.

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He may take a longer route
in order to get a higher fare.

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A restaurant owner knows more
about the safety of his restaurant

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than does his insurance company.

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He might choose
to skimp on sprinklers

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if he's got fire insurance.

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An employee knows
what he's been working on all day

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whereas the manager
maybe does not.

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The employee might choose
to goof off rather than do his job.

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These examples highlight a concept
called the principal-agent problem.

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Often when you hire someone,
that person has more information

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than you do.

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Indeed, that's often why
you pay to hire them.

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In the case of your car,
you are the principal

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and the mechanic is your agent.

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Your incentive
is to get your car fixed

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and not waste too much money.

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His incentive might be
to get as much money

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out of you as possible.

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Given that he has information
about cars that you don't,

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he can lie to charge more.

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In this case there
are conflicting incentives,

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and you don't have
the information to know

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a good deal from a bad deal.

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Ideally, you would like
to align the incentives

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of the mechanic with yours,
so you don't get swindled.

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That is at least, in principle,
how you can solve

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a principal-agent problem.

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No one likes to be ripped off,
but the problem of moral hazard

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runs deeper than just the rip-off.

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The bigger problem
is that the potential for a rip-off

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means that a transaction
maybe less likely to occur

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in the first place.

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If you know the mechanic
may recommend more service

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than is necessary, 
you might, for instance,

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pass on some recommended
precautionary repairs

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and just wait
until your car breaks down.

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Of course, that can be inefficient.

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You’d prefer to perform
that preventive maintenance

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and not break down unexpectedly.

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But because
of asymmetric information,

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you can't trust your agent,
the mechanic,

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and so you pass on those repairs
for fear of being ripped-off.

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So we can see that asymmetric
information can impede trade

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and limit the great benefits
of specialization through markets.

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So what can we do?

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Well, take a moment
to think about this,

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and perhaps you can anticipate
some of the solutions

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we'll discuss in the next video.

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- [Narrator] If you want
to test yourself,

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click “Practice Questions.”

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Or, if you're ready to move on,
just click “Next Video.”

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♪ [music] ♪