TAILIEUCHUNG - Ten Principles of Economics - Part 59

Ten Principles of Economics - Part 59. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. | CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 599 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 competent one. By contrast if the firm offers any lower wage it is sure to hire the incompetent worker. In many situations in life information 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 economic theory. Some of these problems were highlighted in our description of the theory of efficiency wages. These problems however go beyond the study of unemployment. The worker-quality variant of efficiency-wage theory illustrates a general principle called adverse selection. Adverse selection arises when one person knows more about the attributes of a good than another and as a result the uninformed 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 workers changes in a way that is adverse to the firm. Adverse selection arises in many other circumstances. Here are two examples Similarly the worker-effort variant of efficiency-wage theory illustrates a general phenomenon called moral hazard. Moral hazard arises when one person called the agent is performing some task on behalf of another person called the principal. Because the principal cannot perfectly monitor the agent s behavior the agent tends to undertake less effort than the principal considers desirable. The term moral hazard refers to the risk of dishonest or otherwise inappropriate behavior by the agent. In such a situation the principal tries various ways to encourage the agent to act more responsibly. In an employment relationship the firm is the .

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