Weekly I/O #59
Adverse Selection, Moral Hazard, Principal-Agent Problem, First Follower, Reflect on Irritation
Hi friends,
Greetings from Santa Clara!
This week I was captivated by the novel Project Hail Mary by Andy Weir and didn’t read much else. Therefore, I reviewed some interesting concepts I learned in my undergrad finance class. I hope you enjoy it :)
Output
Here's what I've published in the past week.
1. Weekly I/O #58
Last Weekly I/O about Decoy Effect, Low Social Optionality, Make AI Charming to Learn, Experience Valuable than Database, Be Understood after being Clear.
Input
Here's a list of what I'm exploring and pondering on this week.
1. Adverse Selection: Asymmetric information in transactions can lead to the less-informed side potentially making bad choices.
Article: Adverse Selection: Definition, How It Works, and The Lemons Problem
Adverse selection often refers to a situation where sellers have more information that buyers don't have, or vice versa, about some aspects of a product. Therefore, the party with more information exploits this asymmetric information.
For instance, in the market for used cars, a seller knows more about the vehicle they are selling than the buyer. A used car seller may sell a vehicle that looks good on the outside but has mechanical issues that are not obvious. Therefore, a buyer without enough expertise to identify potential issues may end up overpaying for a car with hidden problems, leading to the lemon problem.
Similarly, in the insurance market, individuals with higher risk profiles, such as those with pre-existing medical conditions, are more likely to purchase health insurance than healthy individuals. This can lead to adverse selection for the insurance company, as they may pay more claims to individuals with higher risk profiles than initially expected.
2. Moral Hazard: People are more likely to take risks when they know they won't bear the full consequences of their actions.
Article: Moral Hazard: Definition, Meaning, Examples, and How to Manage
Moral hazard is a situation where people take more risks because they know they will not bear the full consequences of their actions. In other words, one increases exposure to risk because one does not pay the total costs of that risk.
For example, when someone has car insurance, they may be more likely to drive recklessly because they know the insurance company will cover any damages. Similarly, suppose a company receives a bailout from the government. In that case, they may be more inclined to take on risky investments or engage in unethical behavior because they know they will not suffer the full consequences of their actions. In both cases, the party taking the risk has less incentive to act responsibly because they know someone else will bear the costs of their actions.
It's noteworthy that adverse selection arises from a lack of information, while moral hazard arises from a lack of incentives. Adverse selection can lead to unequal or unfair exchanges, while moral hazard can lead to excessive risk-taking or reckless behavior.
3. Principal-Agent problem occurs when one person hires another person to do a job but cannot fully monitor or control their actions, potentially leading to conflicts of interest or suboptimal outcomes.
Article: Moral Hazard: Definition, Meaning, Examples, and How to Manage
The principal-agent problem occurs when one party (the principal) hires another party (the agent) to carry out a task or make decisions, but the agent's incentives might not align with the principal's interests, leading to conflicts of interest and suboptimal outcomes.
For instance, a company's shareholders (the principals) hire a CEO (the agent) to manage the company. However, the CEO may have incentives misaligned with the shareholders' interests. The CEO may prioritize short-term profits over long-term growth because they receive bonuses tied only to the company's short-term performance. This misalignment incentivizes CEO to focus on their own interests rather than those of the shareholders.
Another example is a patient (the principal) hiring a doctor (the agent) to provide medical care. The doctor may have financial incentives to prescribe specific treatments, even if they are not in the best interests of the patient's health. This can lead to over-treatment or unnecessary procedures that may harm the patient.
In brief, don't ask a barber whether you need a haircut, and don't ask an investment banker whether you should go IPO. To mitigate the risks of the principal-agent problem, we need to consider Goodhart's Law in #56.1: "when a measure becomes a target, it ceases to be a good measure".
4. When new artists do weird work, their first followers are the curators that transform their individual weirdness into public art. Make your work easy to find and follow.
Conversation
This popped up in a conversation with my digital art teacher Miguel Novelo when we discussed what art is and the journey of transitioning the display of art pieces from an internet space to a physical gallery. We must put ourselves out there to be discovered, commented on, and understood. Thanks to Miguel Novelo for sharing this with us.
This reminds me of the video: First Follower: Leadership Lessons from Dancing Guy. Another related but different perspective I noted is from Kevin Kelly's: 103 Bits of Advice I Wish I Had Known: "When you lead, your real job is to create more leaders, not more followers."
5. A great way to understand yourself is to seriously reflect on everything you find irritating in others.
This is a good exercise to know more about ourselves. Also from #45.1: "You are precisely as big as what you love and precisely as small as what you allow to annoy you." - Robert Anton Wilson.
That's it. Thanks for reading. Since I always want to know more about my readers, please let me know which input you find most useful or interesting. You can take 5 seconds and reply to this email with a number!
As always, feel free to send me any interesting ideas you came across recently!
Looking forward to learning from you.
Best,
Cheng-Wei