Economics 101A(Lecture 26)Stefano DellaVignaApril 30, 2015

Outline1. The Takeover Game2. Hidden Type (Adverse Selection)3. Empirical Economics: Intro4. Empirical Economics: Home Insurance5. Empirical Economics: Retirement Savings6. Some Advice7. Course Evaluation

1Takeover Game “The Takeover Game” (Samuelson and Bazerman,1985) See hand-out

2Hidden Type (Adverse Selection) Nicholson, Ch. 18, pp. 671-672 Solution of Take-over game— When does seller sell? If bid profitable ( )— Profit of buyer? 1 5 — BUT: Must takeinto account strategic behavior of seller Solution: [ ( )] ( [1 5 ] ) · Pr( )µ¶ 1 5 Pr( )2 25 Pr( ) Solution: 0! No market for take-overs, despite clear benefits. Why?

First type of asymmetric information problems: Hidden Action (Moral Hazard)— Manager can shirk when she is supposed to workhard. Second type of asymmetric information problems:Hidden Type (Adverse Selection)— Informational problem: one party knows morethan the other party.— Example 1: wisdom teeth extraction (Doctors arevery prone to recommend extraction. Is it necessary? Or do they just want to make money.Likely too many wisdom teeth extracted.)— Example 2: finding a good mechanic. (Most people don’t have any idea if they are being told thetruth. People can shop around, but this has considerable cost. Because of this, mechanics cansometimes inflate prices)

Lemons Problem Classic asymmetric information situation is called “LemonsProblem”— (Akerlof, 1970) on used car market— Idea: “If you’re so anxious so sell to me do Ireally want to buy this?” Simple model:— The market for cars has two types, regular cars(probability ) and lemons (probability 1 ). To seller, regular cars are worth 1000, lemonsare worth 500. To potential buyer, regular cars are worth 1500and lemons worth 750.

Which cars should be sold (from efficiency perspective)?— All cars should be sold since more valuable tobuyer.— BUT: buyers do not know type of car, sellers doknow Solve in two stages (backward induction):— Stage 2: Determine buyers willingness to pay— Stage 1: Determine selling strategy of sellers Stage 2. What are buyers’ WTP?— Expected car value 1500 (1 )750 750 750— Notice: is expected probability that car sold isregular (can differ from )

— Buyer willing to pay up to 750 750 Stage 1. Seller has to decide which car to sell— Sell lemon if 500 750 750 YES for all — Sell regular car if 1000 750 750 1 3 Two equilibria1. If 1 3: Sell both types of cars — 1 3 — 750 7502. If 1 3: Sell only lemons — 0 — 750 Market for cars can degenerate: Only lemons sold

Conclusion: the existence of undetectable lemonsmay collapse the market for good used cars Basic message: If sellers know more than buyers,buyers must account for what a seller’s willingness totrade at a price tells them about hidden information Same issues apply to:— Car Insurance. If offer full insurance, only baddrivers take it— Salary. If offer no salary incentives, only lowquality workers apply

3Empirical Economics: Intro So far we have focused on economic models For each of the models, there are important empiricalquestions Consumers:— Savings decisions: Do Americans under-save?— Attitudes toward risk: Should you purchase earthquake insurance?— Self-control problems: How to incentive exerciseto address obesity ‘epidemics’ ?— Preferences: Does exposure to violent media changepreferences for violent behavior?

Producers:— When do market resemble perfect competitionversus monopoly/oligopoly?— Also, what if market pricing is more complicatedthan just choice of price and quantity ? But this is only half of economics! The other half is empirical economics Creative and careful use of data Get empirical answers to questions above (and otherquestions)

4Empirical Economics: Home InsuranceMethodology I. Consumers choose in a menu of options— Choice among options reveals preferences Choice of deductibles in home insurance (Sydnor,2006) Risk Aversion — Take insurance to limit risks However: Limit *large* risks, not small risks (Localrisk-neutrality)— Insure house at all (large) vs. deductible at 250or 500 (small)— Invest in stock market (large) vs. telephone wireinsurance (small)

Dataset 50,000 Homeowners-Insurance Policies 12% were new customersSingle western stateOne recent year (post 2000)Observe Policy characteristics including deductible 1000, 500, 250, 100Full available deductible-premium menuClaims filed and payouts by company

Premium-Deductible MenuChosen DeductibleAvailableFullDeductible Sample10005002501001000500250100 615.78 528.26 1) 615.82 798.63(292.59)(405.78) 99.91 130.89(45.82)(64.85)(40.65)(31.71)(25.80) 86.59 113.44 86.54 73.79 65.65(39.71)(56.20) 133.22 174.53(61.09)(86.47)* Means with standard deviationsin parentheses 99.85 85.14100/500 20% 75.7587/250(27.48) 35%(22.36)(35.23) 133.14 113.52 101.00133/150 89%(54.20)(42.28)(82.57)

Potential Savings with 1000 DedClaim rate?Chosen Deductible 500N 23,782 (47.6%) 250N 17,536 (35.1%)Value of lowerAdditionaldeductible?premium? Potentialsavings?Increase in out-of-pocket Increase in out-of-pocketReduction in yearlySavings per policywith 1000Number of claims payments per claim with a payments per policy with a premium per policy with 1000 deductible 1000 deductibledeductible 1000 deductibleper .59)(1.20)(0.45)(1.28)Average forgone expected savings for all low-deductible customers: 99.88* Means with standard errors in parentheses

Back of the Envelope BOE 1: Buy house at 30, retire at 65,3% interest rate 6,300 expected With 5% Poisson claim rate, only 0.06%chance of losing moneyBOE 2: (Very partial equilibrium) 80%of 60 million homeowners could expectto save 100 a year with “high”deductibles 4.8 billion per year

Consumer Inertia?Percent of Customers Holding each Deductible mber of Years Insured with Company11-1515

Risk Aversion? Simple Standard Model Expected utility of wealth maximizationFree borrowing and savingsRational expectationsStatic, single-period insurance decisionNo other variation in lifetime wealth

CRRA BoundsChosen DeductibleMeasure of Lifetime Wealth (W):(Insured Home Value)min ρmax ρW 1,000256,900N 2,474 (39.5%) 500N 3,424 (54.6%) 250N 367 (5.9%)- 30)

5Empirical Economics: RetirementSavings Methodology II. Differences-in-differences— Consider effect of a change in variable on variable — Ex.: Minimum wage ( ) and employment ( )(Card and Krueger, 1991) Retirement Savings — In the US, most savings forretirement are voluntary (401(k)) Actively choosing to save is. hard Self-control problems: Would like to save more.Just not today! Saving 10% today means lower net earnings today

Brilliant idea: SMRT Plan (Benartzi and Thaler,2005) Offer people to save. tomorrow. Three components of plan:1. Retirement contribution to 401(k) increases by3% at every future wage increase2. This is just default — can change at any time3. Contribution to 401(k) goes up only when wageis increased This works around your biases to make you betteroff:1. Self-control problem. Would like to save more,not today2. Inertia. People do not change the default3. Aversion to nominal (not real) losses.

The results. Setting:— Midsize manufacturing company— 1998 onward

Result 1: High demand for commitment device Result 2: Phenomenal effects on savings rates

Plan triples savings in 4 years Currently offered to more than tens of millions ofworkers Law passed in Congress that gives incentives to firmsto offer this plan: Automatic Savings and PensionProtection Act Psychology & Economics & Public Policy:— Leverage biases to help biased agents— Do not hurt unbiased agents (cautious paternalism) For example: Can we use psychology to reduce energy use?

Summary on Empirical Economics Economics offers careful models to think about human decisions Economics also offers good methods to measure human decisions Starts with Econometrics (140/141) Then go on with applied ecomometrics (142) Empirical economics these days is precisely-measuredsocial science

6Advice1. Listen to your heart2. Trust yourself

3. Take ‘good’ risks:(a) hard courses(b) internship opportunities(c) (graduate classes?)4. Learn to be curious, critical, and frank

5. Be nice to others! (nothing in economics tells youotherwise)

April 30, 2015. Outline 1. The Takeover Game 2. Hidden Type (Adverse Selection) 3. Empirical Economics: Intro . — Salary. If offer no salary incentives, only low-quality workers apply. 3 Empirical Economics: Intro . Psychology & Economics & Public Policy: — Leverage biases to help biased agents