← Principles of Microeconomics

Unit 11: Information, Uncertainty, and Behavioral Economics

What a market does when one side knows something the other doesn't, and where real human choices depart from the rational ideal.

8 topics · 27 questions

Each topic is a path, not a menu: work down it in order and every question builds on the one above. Click any of them to watch the answer draw itself.

Asymmetric Information and Hidden Information

  1. How it worksHow does one side of a transaction holding hidden information change what price a deal can even happen at?
  2. How it worksHow does hidden information about quality make buyers cautious even when a specific seller is being totally honest?
  3. Going furtherWhat happens to a market's average quality once buyers can't tell good products from bad ones at all?
Your turn1 of 2
A seller of a used car knows exactly how well-maintained it has been, but a buyer standing in the lot has no way to verify this. How does this gap in information change what price a deal can even happen at?

Adverse Selection and the Market for Lemons

  1. How it worksHow does a buyer offering only the average price for an unknown-quality car push good-quality sellers to walk away?
  2. How it worksHow does that same unraveling repeat itself, worsening the average quality left on the market at every round?
  3. Going furtherWhat happens to a market for used cars in the extreme case where only lemons remain?
  4. Common mistakeWhy doesn't the market for lemons problem fix itself once buyers simply learn to distrust every seller?
Your turn1 of 2
Buyers in a used car market cannot distinguish good cars from lemons, so they offer only the average price for an unknown-quality car. What happens to sellers who actually have good-quality cars?

Moral Hazard

  1. How it worksHow does being shielded from the full cost of a risk change the amount of care or risk someone takes on?
  2. How it worksHow does an insurance company try to limit moral hazard with deductibles and co-pays?
  3. Common mistakeWhy doesn't moral hazard require the insured person to be acting dishonestly?
Your turn1 of 2
After buying full insurance with no deductible, a driver starts parking in riskier spots and driving a bit less carefully than before. What economic concept does this describe?

Signaling

  1. How it worksHow does taking a costly, hard-to-fake action let a high-quality candidate credibly separate themselves from a low-quality one?
  2. Worked exampleFind why a degree costing 20000 dollars in effort works as a signal when it costs a low-ability worker 40000 dollars but a high-ability worker only 10000 dollars.
  3. Common mistakeWhy doesn't signaling require that the costly action itself teach the signaler anything useful?
Your turn1 of 2
A costly signal, like a degree, costs a low-ability worker 43928 dollars in effort but costs a high-ability worker only 14735 dollars. By how many dollars is the signal cheaper for the high-ability worker?

Screening and Self-Selection

  1. How it worksHow does offering a menu of options let an uninformed party sort customers by which option each one picks?
  2. How it worksHow does a high-risk customer end up self-selecting into a different plan than a low-risk customer would choose?
  3. Going furtherWhat happens to a screening menu once customers realize which option reveals their true type?
  4. Ties togetherHow does screening solve the same information gap that signaling solves, but from the opposite side of the deal?
Your turn1 of 2
An insurance company can't tell which customers are high-risk and which are low-risk, so instead of trying to investigate each one, it offers both an expensive low-deductible plan and a cheap high-deductible plan side by side. What is this strategy called?

Present Bias and Loss Aversion

  1. How it worksHow does present bias make people weight a cost or benefit happening right now far more heavily than an identical one later?
  2. How it worksHow does loss aversion make losing 20 dollars feel worse than gaining 20 dollars feels good?
  3. Going furtherWhat happens to a savings plan once a present-biased person has to choose between spending today and saving for later?
  4. Common mistakeWhy wouldn't a purely rational, self-interested consumer show either present bias or loss aversion at all?
Your turn1 of 2
A person values one hundred dollars received today the same as 159 dollars received in a year, revealing present bias. By how many dollars does the future amount exceed today's hundred dollars?

Anchoring, Framing, and the Endowment Effect

  1. How it worksHow does an arbitrary starting number anchor a later guess or price judgment toward it?
  2. Worked exampleFind the gap the endowment effect predicts when someone would pay 20 dollars for a mug but demands 35 dollars to give up an identical one they already own.
  3. Going furtherWhat happens to a purchase decision when the exact same outcome is framed as a loss instead of a gain?
Your turn1 of 2
The endowment effect predicts a gap when someone would pay 20 dollars for a mug but demands 42 dollars to give up an identical one they already own. What is that predicted gap?

The Sunk Cost Fallacy

  1. How it worksHow does money or effort already spent keep pulling on a decision even though it can never be recovered either way?
  2. Worked exampleFind the rational choice when a 15 dollar movie ticket was already bought but the movie turns out unwatchable after 20 minutes.
  3. Ties togetherHow does the sunk cost fallacy in everyday life relate to why a firm should ignore its own sunk costs when deciding whether to shut down?
Your turn1 of 2
An already-purchased, non-refundable movie ticket cost 17 dollars. Staying to watch the rest of the movie provides 18 dollars worth of enjoyment, while leaving to do something else provides 24 dollars worth of enjoyment. Ignoring the sunk ticket cost, by how many dollars of enjoyment does the better choice beat the worse one?