Information Economics

Information Economics

Consider the following variants on the game of poker: The Certainty Game – 5 cards dealt face up so that all

players can see them The Imperfect Information Game – 3 cards dealt face up

and 2 face down to each player The Imperfect & Asymmetric Information Game – 3

cards dealt face up and 2 cards dealt face down to each player – each player allowed to look at their own face down cards


In the first game there is little/no incentive to bet

In the second game each player is faced with imperfect but symmetric information. Some players may be better at judging how the unseen cards may ‘add value’ to the hand so there is a little scope for skill and betting becomes more likely


In the third game each player has private information

Imperfect & Asymmetric information creates scope for strategic play

Bluffing & Misleading signals through the use of body language & betting behaviour


Some transactions in markets & organizations may feature full information

Many more feature a degree of asymmetric & imperfect information

Hidden information Hidden action

Hidden Information

Occurs when one party to a transaction has more information than the other parties about some exogenous fact relevant to the transaction

Examples include life insurance and Akerlof’s market for lemons (2nd hand cars)

There is an incentive for pre-contract (ex-ante) opportunism which induces adverse selection

Hidden Information in Markets

Originated in insurance markets Asymmetric information between the insurer and

the insured For medical insurance individuals know more about

their health than the insurer Individuals have a better idea of whether insurance

is a ‘good deal’ Insurers tend to end up insuring ‘bad risks’ –

adverse selection

Medical Insurance

Cost of heart by-pass operation is constant at c

The size of the population is N The number of operations performed per

annum is n If everyone was insured:

Prave=n/N

Medical Insurance

If everyone insured the average pay-off would be: Prave=c If the insurer set the premium equal to c he

would break even This presumes everyone takes out the

insurance What if they do not?

Medical Insurance

Assume all individuals are risk-neutral and that individuals have better information about their health than the insurers

Pri is the individual’s assessment of the probability of their making a claim – it is not known by insurers

Medical Insurance

The individuals expected pay-off is: Pri x c

The individual will opt for the medical insurance iff: Pri x c > Prave x c

Pri > Prave

Medical Insurance

Only those with a greater than average risk will choose to insure

Under this scenario the insurer makes a loss Insurer can raise premium but this forces more

individuals not to insure Ultimately premiums are raised to the level where

no-one insures This is the adverse selection problem

Medical Insurance

In practice individuals have different attitudes to risk

Also many do not know precisely their own level of risk

Akerlof’s Market for Lemons

2 second hand cars Some information is readily ascertainable by

both sides to any potential transaction (buyer & seller)

Some information is asymmetrically distributed – it is known by the seller but not by the potential buyer


The ‘value’ of a good second-hand car is £10,000

The ‘value’ of a lemon is £5,000 Assume that 50% of cars are good and 50%

are ‘lemons’ The market price will be £7,500


Owners of lemons will be eager to sell their cars on the open market

Owners of good cars will not Over time this will exert downwards pressure

on price and eventually only lemons will be supplied

Trade in good cars will disappear


Trade between family & friends The importance of guarantees Ex-ante monitoring expenditure by the

potential buyer – e.g. A.A. checks Reputation of dealers

Hidden Information in Organizations

Consider an employee applying for a job elsewhere in the same company

Requires a reference from current ‘boss’ who has the ‘best’ information

Reference writer will highly praise bad employees to get rid of them

Reference writer will be lukewarm about good employees to keep them

Reducing the Impact of Hidden Information

Market Segmentation Self-selection Increase Monitoring Forced risk pooling Internalization

Hidden Action (Moral Hazard)

Having entered into a contract one party is unable to observe the behaviour of the other party who may then have an incentive to engage in post-contract opportunism In Markets - Insurance In Organizations - Shirking

Reducing the Impact of Hidden Action

Monitoring Incentive Pay

Documents

Information Economics