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♪ [music] ♪

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- [Tyler] In the previous video,

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we discussed how[br]asymmetric information

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can lead to moral hazard,

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which can lead [br]to people being ripped off,

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which in turn can lead [br]to markets breaking down.

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Now, there are two types [br]of potential solutions

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to moral hazard problems.

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First, since the problem [br]is asymmetric information,

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you can try to make [br]information less asymmetric.

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If both parties [br]have similar information,

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then one party cannot [br]so easily exploit the other.

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Second, if you can't get rid [br]of the information asymmetry,

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you can try to reduce the incentive[br]of the agent to exploit

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his or her informational advantage.

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One example[br]that you're already familiar with

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works along both[br]of these dimensions:

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user ratings.

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You can get ratings[br]for businesses at sites

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such as Yelp and Angie's List,

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and for products [br]at places such as Amazon.com.

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Reviews give you more information [br]about a product or service,

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and they help balance[br]the information

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between buyer and seller,

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thereby mitigating issues [br]of moral hazard.

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Additionally, the existence [br]of these review sites

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changes the incentives [br]for the sellers.

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In our previous example [br]of the auto mechanic

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we sketched out how your incentive [br]to get your car repaired

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might conflict[br]with the mechanic's incentive

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to milk you for extra money.

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However, the mechanic also[br]has to think about her reputation,

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which is what leads [br]to future business.

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Previously, you might have told,

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well, just a few friends [br]that you got ripped off.

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Now, today, you can write [br]an online review

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and reach a much larger audience, [br]maybe thousands of people.

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A mechanic's online reputation [br]is important to her success

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and provides an incentive [br]for her not to try to exploit

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her informational advantage.

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While review sites are great, [br]the market is continually evolving,

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and some sellers try to fight back

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by faking or manipulating [br]reviews or ratings.

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There's some obvious examples,

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like favorably reviewing [br]your friend's book on Amazon

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if your friend reviews yours.

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But there are more [br]subtle examples as well.

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For instance, some universities [br]invite lots of applicants,

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knowing they will reject them,

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just hoping to boost [br]their rating for exclusivity.

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Reviews are more trustworthy [br]if they come from third parties

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who do not have incentives [br]to bias the review

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one way or the other.

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The magazine Consumer Reports, [br]for example,

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has a reputation[br]for honest reporting

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because it's a non-profit[br]and it accepts no advertisements

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and no funding [br]from commercial sources.

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But there's another problem --

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it's hard to exclude people [br]from produced information.

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Information is also [br]what we call nonrival --

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nonexcludable and nonrival.

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Do those property sound familiar?

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Yes, information[br]has the characteristics

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of a public good.

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Click to go back [br]and review if you need.

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It's hard for Consumer Reports [br]to keep the information it provides

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to only those people [br]who buy the magazine.

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If you hear that Consumer Reports [br]says that brand X of television

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is the very best,

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well you might use that information

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even if you didn't buy [br]the magazine and pay for it.

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In this case, we would say [br]that you are free riding,

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using the benefits[br]of their research

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and testing without contributing [br]to paying the costs.

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Free riding is a problem, however, [br]not because it's unfair or unjust,

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but because it means [br]that information provision

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may be under-provided [br]in the first place.

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As a result, there are fewer [br]trustworthy third parties

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reviewing products and services.

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So, review sites help solve [br]moral hazard issues

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by both balancing the information [br]between buyer and seller,

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and reducing the incentives [br]for the more informed party

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to exploit[br]an informational advantage.

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There are other approaches

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that work solely[br]by modifying the incentives

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of those people[br]with the informational advantages.

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Let's take two examples

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that might seem[br]completely different,

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but are actually, conceptually, [br]pretty similar:

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house inspections,[br]and second opinions from doctors.

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When you buy a house, [br]you typically get a home inspector

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to check out the house [br]and identify potential problems.

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By law in many states,

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these home inspectors [br]cannot also sell services

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to fix any problems[br]they've identified.

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This changes their incentives.

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No longer do they have the incentive

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to overstate[br]potential problem issues

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to inflate the bill.

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Similarly, when you go to a doctor [br]for a second opinion,

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that doctor is simply [br]diagnosing the problem,

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but not doing the actual treatment.

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Just like with the home inspector,

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this eliminates the incentive [br]to run up the bill.

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Both of these examples [br]split the diagnosis of the issue

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from the actual work [br]to address the problem.

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So while the information [br]is still asymmetric,

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there is less of an incentive [br]to exploit that asymmetry.

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By the time you're ready [br]to fix the issue,

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this separate diagnosis by an expert

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allows you to have[br]much more information.

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Maybe now, almost as much [br]as the service provider in some ways.

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This video has covered [br]the various solutions

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to moral hazard issues

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in situations [br]of asymmetric information.

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In the next video,

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we'll take up[br]a different kind of response

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to the asymmetric[br]information problem,

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namely signaling.

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See you then.

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- [Narrator] If you want[br]to test yourself,

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click "Practice Questions."

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Or, if you're ready to move on,[br]just click "Next Video."

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♪ [music] ♪