C H A P T E R 2 6
U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E
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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.
In
many situations in life, in-
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.
The worker-quality variant
of efficiency-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:
◆
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.
◆
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.
Similarly, the worker-effor t variant of efficiency-wage
theor y illustrates a general phenomenon called
moral haz-
ard.
Moral hazard arises when one person, called the
agent,
is per forming some task on behalf of another person, called
the
principal.
Because the principal cannot per fectly monitor
the agent’s behavior, the agent tends to under take less ef-
for t than the principal considers desirable. The term
moral
hazard
refers to the risk of dishonest or other wise 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 imper fectly
monitored workers to shirk
their responsibilities. According to the worker-effor t variant
of efficiency-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:
◆
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.
◆
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.
◆
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
par t 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?
F Y I
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