Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

7.8 SUMMARY 
 
1. Search costs refer to the time and money we spend seeking 
information about a product. The general rule is to continue 
the search for lower prices, higher quality, and so on until the 
marginal benefit from the search equals the marginal cost. In 
most instances, costs, advertising provides a great deal of 
information and greatl
y reduces consumers‘ search costs, 
especially for search goods. These are goods whose quality 
can be evaluated by inspection at the time of purchase (as 
opposed to experience goods, which can only be judged after 
using them). 
2. When one party to a transaction has more information than the 
other on the quality of the product (i.e., in the case of 
asymmetric information), the low-
quality product, or ―lemon£, 
will drive the high-quality product out of the market. One way 
to overcome or reduce such a problem of adverse selection is 
for the buyer to get, or the seller to provide, more information 
on the quality of the product or service. Such is the function of 
brand names, chain retailers, professional licensing, and 
guarantees. Insurance companies try to overcome the 
problem of adverse selection by requiring medical checkups, 
charging different premiums for different age groups and 
occupations, and offering different rates of coinsurance, 

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amounts of deductibility, and length of contracts. The only way 
to avoid the problem entirely is with universal compulsory 
health insurance. Credit companies reduce the adverse 
selection process that they face by sharing ―credit histories‖ 
with other insurance companies. 
3. The problem of adverse selection resulting from asymmetric 
information can also be resolved or greatly reduced by market 
signalling. Brand names, guarantees, and warranties are used 
as signals for higher-quality products, for which consumers are 
willing to pay higher prices. The willingness to accept 
coinsurance and deductibles signals low-risk individuals to 
whom insurance companies can charge lower premiums. 
Credit companies use good credit histories to make more 
credit available to good-quality borrowers, and firms use 
educational certificates to identify more-productive potential 
employees who may then receive higher salaries. 
4. The insurance market also faces the problem of moral hazard, 
or the increase in the probability of an illness, fire, or other 
accident when an individual is insured than when he or she is 
not. If not contained, moral hazard leads to unacceptably high 
insurance costs. Insurance companies try to overcome the 
problem of moral hazard by specifying the precautions that an 
individual or firm must take as a condition of insurance, and by 
coinsurance (i.e., insuring only part of the possible loss). The 
problem of moral hazard arises whenever an externality is 
present (i.e. any time an economic agent can shift some of its 
costs to others). 
5. Because ownership is divorced from control in the modern 
corporation, a principal-agent problem arises. This refers to 
the fact that managers seek to maximise their own benefits 
rather than the owners‘ or principals‘ interests, which are to 
maximise the total profits or value of the firm. The firm may 
use golden parachutes (large financial payments to managers 
if they are forced out or choose to leave if the firm is taken 
over by another firm) to overcome the managers‘ objections to 
a takeover bid that sharply increases the value of the firm. The 
firm may also set up generous deferred-compensation 
schemes for its managers to settle their long-term interests 
with those of the firm. 
6. According to the efficiency wage theory, firms willingly pay 
higher than equilibrium wages to induce workers to avoid 
shirking or slacking off on the job. The no-shirk constraint 
curve is positively sloped and shows that the efficiency or 
minimum wage that the firm must pay to avoid shirking is 
higher the smaller the level of unemployment. The equilibrium 

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efficiency wage is given by the i
ntersection of the firm‘s 
demand curve for labour and the no-shirking curve.