L25

Asymmetric Information

Road map1) Consumers choice

2) Equilibrium, Producers

(Pareto efficiency)

3) Market Failures

- fixed cost: monopoly and oligopoly

- externalities and public goods

- asymmetric information

Asymmetric Information Assumption: full information about the

traded commodities

What about following markets? 1. Medical services: a doctor knows more

than does the patient.2. Insurance: buyer knows more about

his riskiness than does the seller. 3. Used cars: a car’s owner knows more

about it than does a potential buyer

Problem: asymmetric information

Today

Q: how does asymmetric information affect the functioning of a market?

Important phenomena0 adverse selection (hidden information)0 signaling 0 moral hazard (hidden action)

Market for “lemons”

Second hand car market. Types of cars: “lemons” and “plums”.

Benchmark: Perfect information

Gains-to-Trade (50% - 50%)

Lemon Plum

Seller 1000 2000

Buyer 1200 2400

Asymmetric information

Asymmetric information (50% - 50%)

Gains-to-trade and BS, SS

Lemon Plum

Seller 1000 2000

Buyer 1200 2400

Separating equilibrium

Asymmetric information ( , )

Lemon Plum

Seller 1000 2000

Buyer 1200 2400

1

Pooling equilibrium

Asymmetric information ( , )

Gains-to-trade BS and SS

Lemon Plum

Seller 1000 2000

Buyer 1200 2400

1

Adverse Selection

Separating equilibrium “too many” lemons “crowd out” the plums from the market. gains-to-trade are reduced since no plums are traded Bad for plum owners

Pooling equilibrium Lemon owners “hide behind” the plums Somewhat bad for plum owners Pareto efficiency

Probability of “bad type” is high: compulsory insurance

1/ 3

1/ 3

Signaling

Asymmetric information bad for “good” types

Incentive: Credible signal of high-quality

Examples of signals: warranties, professional credentials, references from previous clients, costly adds, education etc.

Signaling (in Labor Market) Two types of managers

- high-ability manager has productivity (a plum)

- low-ability manager has productivity (a lemon) Fraction of high-productivity managers

Competitive markets

Benchmark: No signal (pooling)

1/ 2

( | )w E a I

1ha 0la

Equilibrium with signaling

Signal: MBA education Managers can chose the level of education

Cost of education (MBA) For high-ability worker education costless For low-ability worker

Benefit of education MBA has no effect on workers’ productivities Talent not observed but MBA diploma yes - signal It is a deadweight loss

Q: Is there a separating equilibrium with signaling?

( ) 0h hc e ( ) 0.2l l lc e e

,l he e

(Non) Credible signal

Can we separate with e=2?

1, 0, ( ) 0, ( ) 0.2h l h h l l la a c e c e e

(Non) Credible signal

Credibility condition

1, 0, ( ) 0, ( ) 0.2h l h h l l la a c e c e e

A credible signal

Can we separate now?

Signal more costly to low type Deadweight loss (burning money) Common in real world: adds

1, 0, ( ) 0.1 , ( ) 0.2h l h h h l l la a c e e c e e

Moral Hazard (hidden action)

With full car insurance are you more likely to leave your car unlocked?

With fixed hourly wage is your effort at work reduced?

Moral hazard is a reaction to incentives to increase the risk of a loss

A consequence of asymmetric information (hidden action).

Moral hazard

Perfect information: full insurance Asymmetric information:- partial insurance- contract that depends on output

To assume proper incentives