Naked Economics: Undressing the Dismal Science pdfdrive com

CHAPTER
5

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Economics of Information:
McDonald’s didn’t create a better hamburger
W
hen Bill Clinton ran for president in 1992, he floated the idea of Hope
Scholarships. The Clinton plan (based on an earlier experiment at Yale) was
seemingly elegant: Students could borrow money for college and then repay the
loans after graduation with a percentage of their annual income rather than the
usual fixed payments of principal plus interest. Graduates who went on to
become investment bankers would owe more in student loans than graduates
who counseled disadvantaged teens in poor neighborhoods, which was exactly
the point. The plan was designed to address the concern that students graduating
with large debts are forced to do well rather than do good. After all, it is hard to
become a teacher or a social worker after graduating with $75,000 in student
loans.
In theory, the program would finance itself. Administrators could determine
the average postgraduation salary for eligible students and then calculate the
percentage of income they would have to pay in order for the program to recoup
its costs—say 1.5 percent of annual income for fifteen years. Students who
became brain surgeons would pay back more than average; students who fought
tropical diseases in Togo would pay less. On average, the high and low earners
would cancel each other out and the program would break even.
There was just one problem: The Hope Scholarships had no hope of working,
at least not without a large, ongoing government subsidy. The problem was a
crucial asymmetry of information: Students know more about their future career
plans than loan administrators do. College students never know their future plans
with certainty, but most have a good idea whether their postgraduation income
will be more or less than average—which is enough to determine if a Hope
Scholarship would be more or less expensive than a conventional loan. Aspiring
Wall Street barons would avoid the program because it’s a bad deal for them.
Who wants to pay back 1.5 percent of $5 million every year for fifteen years
when a conventional loan would be much cheaper? Meanwhile, the world’s
future kindergarten teachers and Peace Corps volunteers would opt in.
The result is called adverse selection; future graduates sort themselves in or
out of the program based on private information about their career plans. In the
end, the program attracts predominantly low earners. The repayment
calculations, based on the average postgraduation salary, no longer apply and the
program cannot recover its costs. One may assume that Mr. Clinton ignored

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what his advisers almost certainly told him about the Yale experiment: It was
quietly canceled after five years, both because repayments fell short of
projections and because the administrative costs were prohibitive.
What we don’t know can hurt us. Economists study how we acquire
information, what we do with it, and how we make decisions when all we get to
see is a book’s cover. Indeed, the Swedish Academy of Sciences recognized this
point in 2001 by awarding the Nobel Prize in Economics to George Akerlof,
Michael Spence, and Joseph Stiglitz for their seminal work on the economics of
information. Their work explores the problems that arise when rational people
are forced to make decisions based on incomplete information, or when one