The importance of information

That information matters, or rather that asymmetric information matters, is one of the most obvious, if not fully appreciated, ideas in economics. While reading Charles Wheelan's book "Naked Economics: Undressing the Dismal Science" I came across a nice illustration of this. Wheelan begins his chapter on the economics of information with the following story:

"When Bill Clinton ran for president in 1992, he floated the idea of Hope Scholarshps. 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 $50,000 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."

But as Wheelan points out there is a problem here. To make this scheme work it would need an ongoing government subsidy. Why? The answer is, of course, asymmetric information. Students know more about what they want to do after university than the administrators of the loan scheme do. The students can use this information to help them estimate whether or not the Hope Scholarship would be more or less expensive for them than a conventional loan. If you are an aspiring Wall Street baron, or the next Bill Gates, the Scholarship would be a bad idea. Who wants to pay back, say, 1.5% of $5 million, or what ever Wall Street tycoons make, when a normal loan would be cheaper. On the other hand, for a future kindergarten teacher or volunteer social worker, a Hope Scholarship looks great, their repayments would be less than on a conventional loan.

The scheme suffers from adverse selection. Future graduates sort themselves into or out of the program based, in part, on their private information about their career plans. The Hope scheme attracts mainly those with low future earning prospects. The repayment calculations, based on the average postgraduate wage, are no longer relevant and the program is unable to cover its costs. Wheelan notes that the Yale experiment, on which the Clinton plan was based, was closed down after five years, both because repayments were less than projections and because the schemes running costs were prohibitive.

Perhaps this helps answer Stephen Dubner's question 'What Does A Presidential Candidate's Economic Adviser Actually Do?' They can explain adverse selection to their candidate.