L25

1
L25

• Asymmetric Information

2
Structure of the course

• 1) Consumers choice
• 2) Equilibrium, Producers
• (Pareto efficiency)
• 3) Market Failures
• - fixed cost monopoly and oligopoly
• - externalities and public goods
• - asymmetric information

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Asymmetric Information

• Assumption full information about the traded
  commodities
• What about following markets?
• Medical services a doctor knows more than does a
  patient.
• Insurance a buyer knows more about his riskiness
  than does the seller.
• Used cars a cars owner knows more about it than
  does a potential buyer
• Problem asymmetric information

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Today

• Q how does asymmetric information affect the
  functioning of a market?
• Important phenomena
• adverse selection (hidden information)
• signaling
• moral hazard (hidden action)

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Market for lemons

• Market for used cars (Akerlof 1970)
• Types of cars lemons and plums.
• Proportion 50 - 50
• TPS (Total Potential Surplus)

Lemon Plum
Seller 1000 2000
Buyer 1200 2400
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Benchmark perfect information

• Prices (halfway)
• Buyers and sellers surplus
• TPS and BSSS?

Lemon Plum
Seller 1000 2000
Buyer 1200 2400
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Asymmetric information
Lemon Plum
Seller 1000 2000
Buyer 1200 2400

• Asymmetric information (50 - 50)
• TPS and BS, SS
• Separating Equilibrium

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Separating equilibrium
Lemon Plum
Seller 1000 2000
Buyer 1200 2400

• Asymmetric information ( , )

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Pooling equilibrium
Lemon Plum
Seller 1000 2000
Buyer 1200 2400

• Asymmetric information ( , )
• Efficient outcome

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Adverse Selection

• Separating equilibrium
• Lemons crowd out plums from the market.
• Surplus is reduced since no plums are traded
• Very bad for plum owners
• Pooling equilibrium
• Lemon owners hide behind the plums
• Somewhat bad for plum owners
• Pareto efficiency (full surplus)
• Probability of bad type is high compulsory
  insurance

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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.

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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)

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Equilibrium with signaling

• Signal MBA education
• Years 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
• Q Is there a separating equilibrium with
  signaling?

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(Non) Credible signal

• Is MBA a credible signal with e2?
• Suppose

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Credible signal

• Credibility condition

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A credible signal

• Can we separate now?
• Same credibility condition
• Deadweight loss (burning money)
• Common in real world adds

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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).

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Moral hazard

• Perfect information full insurance
• Asymmetric information
• partial insurance
• contract that depends on output
• To induce proper incentives