Applied Microeconomics

1
Applied Microeconomics

• Asymmetric Information

2
Outline

• Adverse selection
• Signaling
• Screening

3
Readings

• Kreps Chapter 18
• Perloff Chapter 19
• Zandt 12C

4
Introduction

• What happens when some market participants know
  more than others?
• Examples
• Sellers who know more about the quality of their
  product than prospective buyers
• Workers who know more about their skills than
  prospective employees
• Insiders who know more about a firms value than
  outside shareholders

5
Types of Information Asymmetries

• Unobservable characteristics adverse selection
• Unobservable actions moral hazard

6
Adverse Selection

• In 1994, the average car depreciated 37 in its
  first year and 13 more under the second year
• 35 of all cars were sold through car
  dealerships, typically offering warranties
• The average price of a used car in 1994 was about
  11,500, but the average private-sale price for a
  used car was about 2,000 less

7
Adverse Selection

• Adverse selection occurs when an informed
  individuals trading decision depends on her
  unobservable characteristics in a manner that
  adversely affects the uninformed agents in the
  market.

8
Adverse Selection
9
Example Market for Lemons

• Suppose two types of cars good quality in share
  g and bad quality lemons in share 1-g
• Finite number of sellers with reservation prices
  1800 Euros for good cars and 800 Euros for bad
  cars
• Numerous risk-neutral buyers with reservation
  prices 2000 Euros for good cars and 1000 Euros
  for lemons

10
Example Market for Lemons

• If quality observable to buyers, then both types
  of cars would be traded at prices 2000 and 1000
  respectively
• If quality unobservable to buyers, and both cars
  are offered, then buyers are prepared to pay
  2000g(1-g)100010001000g
• Sellers of good cars are willing to sell when
  10001000g1800, or in other words if g80

11
Example Market for Lemons

• What if the share of good cars is less than 80?
• Then only bad cars are offered, and, the buyers
  anticipating this, offer 1000
• Good cars are thus driven out of the market!

12
Example Market for Lemons
Price
13
Remedies

• Screening
• Signaling

14
Screening

• Remember how firms practicing second-degree price
  discrimination could choose the quality and
  tariffs of goods such that different types
  self-select different goods/bundles?
• In the same manner a firm with no information can
  screen possible counterparties
• Screening refers to activities undertaken by the
  party without private information in order to
  separate different types of the informed party
  along some dimension

15
Examples of Screening
16
Signaling

• In markets with adverse selection, an informed
  party of high quality may overcome the adverse
  selection problem by signaling his type
• However, the cost of the signal must be such
  that
• It is not in the interest of an informed party of
  low quality to imitate and the send the same
  signal
• It is not too expensive for the high type to
  signal

17
Examples

• High-ability workers can signal their ability to
  firms by acquiring a certain level of education
• Entrepreneurs with profitable projects can signal
  the profitability of the project to VCs by
  offering holding on to an equity stake in the
  venture
• Car dealers can signal the quality of a used car
  by offering a warranty

18
Spences Model of Labor Market Signaling

• Consider a competitive labor market with workers
  of marginal productivity L in share q, and
  workers of marginal productivity HgtL in share 1-q
• All workers are assumed to have a reservation
  wage of 0
• Firms want to hire workers to perform a task, but
  ability is not observable to them

19
Spences Model of Labor Market Signaling

• With symmetric information low productivity
  workers would be paid a wage of wLL and high
  productivity workers a wage of wHH
• With asymmetric information and no way for
  employers to separate types there would be an
  equilibrium where all workers received a wage of
  wqL(1-q)H

20
Separating Equilibrium

• Suppose now that high productivity workers can
  get a degree attending school at a cost (psychic
  and economic) c and that low productivity workers
  cannot graduate from school
• Assume for simplicity that the productivity of
  the worker is not affected by the education

21
Pooling Equilbria

• If H-cgtqL(1-q)H, or equivalently q(H-L)gtc, only
  a separating equilibrium, where only
  high-productivity workers go to school and firms
  rightly believe that only graduates are of high
  productivity, is possible
• If on the other hand H-cltL, or equivalently
  H-Lltc, then only a pooling equilibrium with a
  uniform wage for everyone is possible
• If q(H-L)cH-L, then both types of equilibria
  are possible

22
Equilibria
c
Pooling
cq(H-L)
cH-L
Separating
Both
1
q
23
Problems

• If education does not raise productivity, then
  signaling is often socially inefficient
• In our example, output and total wages are the
  same with and without signaling, but education is
  costly
• Low productivity workers are definitely worse off
• If wgtH-cgtL, then high-ability workers are also
  worse off
• Reason is that private returns to education
  exceeds net social returns
• Education can be socially efficient when it
  raises total output (lemons market) or
  productivity

24
Problems

• Embarrassment of riches
• Hard to make predictions
• Not only both separating and pooling equilibria
• Also separating equilibria with different costs
  of education for high-productivity workers
• Some equilibria Pareto dominate others

25
Problems

• Self-confirming equilibria are possible
• Suppose employers believe that in addition to
  education some observable and completely
  independent characteristic such as sex or skin
  color is a signal of productivity
• Even if the share of low- and high-productivity
  workers is the same among men and women, we could
  have a separating equilibrium among male workers
  and a pooling equilibrium among female workers

26
Conclusion

• Adverse selection occurs when asymmetric
  information about characteristics affect some
  party adversely
• Screening is when the uninformed party designs
  contracts to elicit information about the
  characteristics of the informed party
• Signaling is when the informed party takes a
  costly action in order to convey information
  about his type to the uninformed party