Chapter 17

Principal–Agent Issues and Adverse Selection: Can Everyone Agree?

In This Chapter

arrow Working together as principals and agents

arrow Eliminating information inequality

arrow Reducing adverse selection’s poor choices

arrow Minimizing moral hazard

It’s a well-known childhood taunt: “I know something you don’t know.” Whenever children use this taunt, you know that they’ve pulled out the heavy artillery in a battle of wits. And as I was once told, don’t engage in a battle of wits unless you come fully armed.

That childhood taunt has special significance in managerial economics. Because individuals tend to be motivated by self interest, yet must interact with one another in mutually beneficial exchange, it’s very important that they have the same information. But frequently everyone participating in an exchange doesn’t have the same information. These situations have asymmetric information, and if I know something you don’t know, I can skew the exchange to my benefit. I say the used car I’m trying to sell you is great; how do you know whether or not it’s great? If one individual possesses better ...

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