1. Asymmetric Information
chapter 21
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Learning Objectives Understand how adverse selection impacts markets.
Explain the concepts of signaling and screening.
Understand the effects of competitive signaling and screening on resource allocation, and discuss the implications for government policy.
Explain how moral hazard can impact a trading relationship.
Describe how an incentive scheme can create incentives to take favorable actions, and some of the potential problems with providing incentives.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

3. Overview
Informational asymmetries occur when one party to a transaction is less well-informed than another
When the uninformed party may be reluctant to trade, adverse selection may cause markets to perform poorly
The informed individual may take a costly action (signaling) to influence others’ beliefs, or the uninformed party may present an informed party with a collection of options (screening), counting on the choices of that party to reveal what she knows
Moral hazard occurs when the informed party takes actions that a trading partner cannot observe, and that affect the benefits the partner receives from the trade
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4. Adverse Selection and Lemons
In a used-car market, sellers want to sell bad cars (“lemons”) and keep good ones
Thus, buyers of used cars must be wary of quality, and that consideration drives the price of a used car down and reduces the number of good cars owners are willing to sell
In some cases, adverse selection can drive good cars from the market completely
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

5. Adverse Selection in a Labor Market
Consider the labor market for entry-level software programmers in Palo Alto, California
Suppose that each worker has either high or low ability
A high-ability worker generates $12,000 of profit per month
A low-ability worker generates only $6,000
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6. Demand and Supply for Software Programmers
When a worker’s ability is observable, high- and low-ability workers receive different wages
In a competitive labor market, employers hire 400 low-ability workers at a monthly wage of $6,000 and 500 high-ability workers at $12,000
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7. Ability is Not Observable by Employers
At every wage above $2,000, the number of low-ability workers willing to work is double the number of high-ability workers
On average, a worker generates a profit of $8,000 per month
The equilibrium wage is $8,000 and 900 workers are hired (300 high-ability and 600 low-ability)
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8. Market Unraveling
Market unraveling occurs in settings with adverse selection when the presence of unattractive trading partners drives attractive trading partners out of the market by altering the prices at which they can trade
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9. Market Unraveling Due to Adverse Selection
Mix of low- and high-ability workers
Only low-ability workers
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10. Responses to Adverse Selection
When adverse selection leads to market failures, governments and private organizations often respond to reduce potential economic losses
Examples
Government-mandated minimum quality standards, which reduce the asymmetry of information
Government-provided insurance (social insurance)
On eBay, past purchasers can post reviews of a seller’s performance
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

11. Signaling
Signaling occurs when someone takes a costly action to influence others’ beliefs
Signaling offers a partial solution to problems that arise from adverse selection
Example: many dealers sell used cars with warranties. Offering a warranty serves as a signal that the seller has a high-quality car.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

12. A Model of Educational Attainment
The greater the worker’s ability, the smaller is the wage increase required to compensate for an increase in education. That pattern reflects an assumption that education is easier and/or more pleasant for those with greater academic talent.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

13. Market Equilibria with Asymmetric Information
In a separating equilibrium, people with different information choose different alternatives
In a pooling equilibrium, people with different information choose the same alternative
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

14. Separating Equilibrium
Low-ability workers receive the minimum amount of education required by law (10 years), while high-ability workers stay in school longer ( 𝐸 𝐻 years)
Firms pay $50 per hour to those with years of schooling, and $20 per hour to those with 10 years of schooling
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

15. Screening
Screening occurs when a less-informed party presents an informed party with a collection of options, and counts on the choices of that party to reveal what she knows
Examples
Insurance companies allow clients to customize policies in a number of ways (e.g., size of deductible)
An employer who wants to hire a certain type of worker may design the position in a way that attracts applicants with the desired characteristics and repels others
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16. A Model of Workplace Responsibilities
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

17. When Employers Know Workers’ Abilities
$10 per task
$5 per task
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

18. Market Equilibria with Asymmetric Information
If an employer offers workers a choice between two different rates of compensation per task, one high and one low, and places no requirements on the number of tasks performed, all workers will choose the higher rate of compensation.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

19. Voluntary Sorting by Workers
Two types of jobs
Perform 60 tasks at $480 a day (rate of $8 per task)
Perform 20 tasks at $120 a day (rate of $6 per task)
Workers self-select into different jobs
High-ability workers choose point C
Low-ability workers choose point D
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20. A Possible Role for the Government
In the screening equilibrium of a competitive insurance market, high-risk individuals get full coverage
Low-risk individuals end up accepting large deductibles and high co-payments
Because they are risk-averse, low-risk individuals would like to buy more insurance
By compelling participation in a social insurance program, the government can typically achieve a Pareto improvement
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

21. Moral Hazard
Moral hazard is present when one party to a transaction takes actions that a trading partner cannot observe, and that affect the benefits the partner receives from the trade
The uninformed party wants to ensure that her trading partner takes actions that promote her interests
An incentive scheme is a contract or compensation policy that ties rewards or punishments to performance, designed in a manner to induce desirable behavior
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

22. Efficiency and Incentive Pay
Benefits to employer
Efficient outcome
Salesperson’s cost of effort
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

23. Incentive Pay and Effort
Lower than efficient outcome
$1,200 per week plus a bonus of $500 for each car the salesperson sells (assuming each hour of high effort generates a 4% chance of selling a car.)
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

24. Efficient Incentive Contract
Base pay of $600 plus a bonus of $1,000 for each car sold by salesperson
Efficient outcome
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

25. Costs of Incentives
Incentive schemes may transfer part or all of the risk and uncertainty to the risk-averse individual
Incentive pay induces employees to concentrate only on measured aspects of performance
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

26. Review
Adverse selection is present if an informed individual is more willing to trade when trading is less advantageous for an uninformed trading partner
Signaling occurs when an informed individual undertakes a costly activity to influence others’ beliefs
Screening occurs when the less-informed party presents the informed party with a collection of options, and counts on the choices of the informed party to reveal what she knows
With moral hazard, the informed party takes action that a trading partner cannot observe, and that affects the benefits the partner receives from the trade
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.