1. Chapter Nineteen Asymmetric Information

2. © 2009 Pearson Addison-Wesley. All rights reserved. 19-2 Topics  Problems Due to Asymmetric Information.  Responses to Adverse Selection.  How Ignorance About Quality Drives Out High-Quality Goods.  Price Discrimination Due to False Beliefs About Quality.  Market Power from Price Ignorance.  Problems Arising from Ignorance When Hiring.

3. © 2009 Pearson Addison-Wesley. All rights reserved. 19-3 Problems Due to Asymmetric Information  adverse selection - opportunism characterized by an informed person’s benefiting from trading or otherwise contracting with a less-informed person who does not know about an unobserved characteristic of the informed person

4. © 2009 Pearson Addison-Wesley. All rights reserved. 19-4 Problems Due to Asymmetric Information  moral hazard - opportunism characterized by an informed person’s taking advantage of a less informed person through an unobserved action

5. © 2009 Pearson Addison-Wesley. All rights reserved. 19-5 Controlling Opportunistic Behavior Through Universal Coverage  Adverse selection can be prevented if informed people have no choice.  A government can avoid adverse selection by providing insurance to everyone or by mandating that everyone buy insurance.

6. © 2009 Pearson Addison-Wesley. All rights reserved. 19-6 Equalizing Information  screening - an action taken by an uninformed person to determine the information possessed by informed people.  signaling - an action taken by an informed person to send information to an uninformed person.

7. © 2009 Pearson Addison-Wesley. All rights reserved. 19-7 Lemons Market with Fixed Quality  When buyers cannot judge a product’s quality before purchasing it, low-quality products—lemons—may drive high- quality products out of the market.

8. © 2009 Pearson Addison-Wesley. All rights reserved. 19-8 Lemons Market with Fixed Quality  Cars that appear to be identical on the outside often differ substantially in the number of repairs they will need.  Some cars —lemons— have a variety of insidious problems that become apparent to the owner only after the car has been driven for a while.  The seller of a used car knows from experience whether the car is a lemon.  We assume that the seller cannot alter the quality of the used car

9. © 2009 Pearson Addison-Wesley. All rights reserved. 19-9 Lemons Market with Fixed Quality  Suppose that there are many potential buyers for used cars.  All are willing to pay $1,000 for a lemon and $2,000 for a good used car.

10. © 2009 Pearson Addison-Wesley. All rights reserved. 19-10 Figure 19.1 Markets for Lemons and Good Cars P r ice of a lemon, $ 0 Lemons peryear D L 1,000 (a) Marketfor Lemons P r ice of a good ca r, $ 2,000 Good cars peryear D G 0 (b) Marketfor Good Cars

11. © 2009 Pearson Addison-Wesley. All rights reserved. 19-11 Lemons Market with Fixed Quality  1,000 owners of lemons and 1,000 owners of good cars are willing to sell.  The reservation price of owners of lemons— the lowest price at which they will sell their cars—is $750.  The reservation price of owners of high- quality used cars is v, which is less than $2,000.

12. © 2009 Pearson Addison-Wesley. All rights reserved. 19-12 Figure 19.1 Markets for Lemons and Good Cars P r ice of a lemon, $ 750 0 Lemons peryear 1,000 S L D L 1,500 1,000 (a) Marketfor Lemons e P r ice of a good ca r, $ 2,000 Good cars peryear 1,000 S 2 S 1 D G 1,750 1,500 1,250 0 (b) Marketfor Good Cars E

13. © 2009 Pearson Addison-Wesley. All rights reserved. 19-13 Lemons Market with Fixed Quality  If both sellers and buyers know the quality of all the used cars before any sales take place, all the cars are sold, and good cars sell for more than lemons. This market is efficient because the goods go to the people who value them the most. All the cars are sold if everyone has the same information

14. © 2009 Pearson Addison-Wesley. All rights reserved. 19-14 Lemons Market with Fixed Quality  The amount of information they have affects the price at which the cars sell.  If no one can tell a lemon from a good car at the time of purchase, both types of cars sell for the same price.

15. © 2009 Pearson Addison-Wesley. All rights reserved. 19-15 Lemons Market with Fixed Quality  Suppose that everyone is risk neutral and no one can identify the lemons: Buyers and sellers are equally ignorant.  A buyer has an equal chance of buying a lemon or a good car.  The expected value of a used car is

16. © 2009 Pearson Addison-Wesley. All rights reserved. 19-16 Lemons Market with Fixed Quality  This market is efficient because the cars go to people who value them more than their original owners. Sellers of good-quality cars are implicitly subsidizing sellers of lemons.

17. © 2009 Pearson Addison-Wesley. All rights reserved. 19-17 Asymmetric Information.  If sellers know the quality but buyers do not, this market may be inefficient:  The better-quality cars may not be sold even though buyers value good cars more than sellers do.  The equilibrium in this market depends on whether the value that the owners of good cars place on their cars, v, is greater or less than the expected value of buyers, $1,500.

18. © 2009 Pearson Addison-Wesley. All rights reserved. 19-18 Asymmetric Information.  There are two possible equilibria:  All cars sell at the average price, or  only lemons sell for a price equal to the value that buyers place on lemons.

19. © 2009 Pearson Addison-Wesley. All rights reserved. 19-19 Figure 19.1 Markets for Lemons and Good Cars P r ice of a lemon, $ 750 0 Lemons peryear 1,000 S L D L D * 1,500 1,000 (a) Marketfor Lemons f e P r ice of a good ca r, $ 2,000 Good cars peryear 1,000 S 2 S 1 D G D * 1,750 1,500 1,250 0 (b) Marketfor Good Cars F E

20. © 2009 Pearson Addison-Wesley. All rights reserved. 19-20 Asymmetric Information.  Consequently, asymmetric information does not cause an efficiency problem,  but it does have equity implications.  Sellers of lemons benefit and sellers of good cars suffer from consumers’ inability to distinguish quality.

21. © 2009 Pearson Addison-Wesley. All rights reserved. 19-21 Asymmetric Information.  Now suppose that the sellers of good cars place a value of v = $1,750 on their cars and thus are unwilling to sell them for $1,500.  As a result, the lemons drive good cars out of the market.  Buyers realize that, at any price less than $1,750, they can buy only lemons.  Consequently, in equilibrium, the 1,000 lemons sell for the expected (and actual) price of $1,000, and no good cars change hands.

22. © 2009 Pearson Addison-Wesley. All rights reserved. 19-22 Asymmetric Information.  This equilibrium is inefficient because high-quality cars remain in the hands of people who value them less than potential buyers do.

23. © 2009 Pearson Addison-Wesley. All rights reserved. 19-23 Solved Problem 19.1  Suppose that everyone in our used-car example is risk neutral, potential car buyers value lemons at $1,000 and good used cars at $2,000, the reservation price of lemon owners is $750, and the reservation price of owners of high-quality used cars is $1,750.The share of current owners who have lemons is θ [in our previous example, the share was θ = 1 2 = 1,000/(1,000 + 1,000)]. For what values of θ do all the potential sellers sell their used cars? Describe the equilibrium.

24. © 2009 Pearson Addison-Wesley. All rights reserved. 19-24 Lemons Market with Variable Quality  Suppose that it costs $10 to produce a low- quality book bag and $20 to produce a high- quality bag,  consumers cannot distinguish between the products before purchase,  there are no repeat purchases, and  consumers value the bags at their cost of production.  The five firms in the market produce 100 bags each.  A firm produces only high-quality or only low- quality bags.

25. © 2009 Pearson Addison-Wesley. All rights reserved. 19-25 Lemons Market with Variable Quality  If one firm makes a high-quality bag and all the others make low-quality bags, the expected value per bag to consumers is  Thus, if one firm raises the quality of its product, all firms benefit because the bags sell for $12 instead of $10.

26. © 2009 Pearson Addison-Wesley. All rights reserved. 19-26 Lemons Market with Variable Quality  Because the high-quality firm incurs all the expenses of raising quality, $10 extra per bag, and reaps only a fraction, $2, of the benefits, it opts not to produce the high-quality bags.  Therefore, due to asymmetric information, the firms do not produce high-quality goods even though consumers are willing to pay for the extra quality.

27. © 2009 Pearson Addison-Wesley. All rights reserved. 19-27 Limiting Lemons  Laws to Prevent Opportunism.  Consumer Screening.  Third-Party Comparisons.  Standards and Certification.  Signaling by Firms.

28. © 2009 Pearson Addison-Wesley. All rights reserved. 19-28 Price Discrimination Due to False Beliefs About Quality  One way in which firms confuse consumers is to create noise by selling virtually the same product under various brand names.

29. © 2009 Pearson Addison-Wesley. All rights reserved. 19-29 Market Power from Price Ignorance  Suppose that many stores in a town sell the same good.  If consumers have full information about prices, all stores charge the full-information competitive price, p*.  If one store were to raise its price above p*, the store would lose all its business.  Each store faces a residual demand curve that is horizontal at the going market price and has no market power.

30. © 2009 Pearson Addison-Wesley. All rights reserved. 19-30 Market Power from Price Ignorance  If consumers have limited information about the price that firms charge for a product, one store can charge more than others and not lose all its customers.  Customers who do not know that the product is available for less elsewhere keep buying from the high-price store.  Thus, each store faces a downward-sloping residual demand curve and has some market power.

31. © 2009 Pearson Addison-Wesley. All rights reserved. 19-31 Tourist-Trap Model  You arrive in a small town near the site of the discovery of gold in California. Souvenir shops crowd the street. Wandering by one of these stores, you see that it sells the town’s distinctive snowy: a plastic ball filled with water and imitation snow featuring a model of the Donner Party. You instantly decide that you must buy at least one of these tasteful mementos— perhaps more if the price is low enough. Your bus will leave very soon, so you can’t check the price at each shop to find the lowest price. Moreover, determining which shop has the lowest price won’t be useful to you in the future because you do not intend to return anytime soon.

32. © 2009 Pearson Addison-Wesley. All rights reserved. 19-32 Tourist-Trap Model  Let’s assume that you and other tourists have a guidebook that reports how many souvenir shops charge each possible price for the snowy, but the guidebook does not state the price at any particular shop. There are many tourists in your position, each with an identical demand function.

33. © 2009 Pearson Addison-Wesley. All rights reserved. 19-33 Tourist-Trap Model  It costs each tourist c in time and expenses to visit a shop to check the price or buy a snowy.  Thus, if the price is p, the cost of buying a snowy at the first shop you visit is p + c.  If you go to two souvenir shops before buying at the second shop, the cost of the snowy is p + 2c.

34. © 2009 Pearson Addison-Wesley. All rights reserved. 19-34 When Price Is Not Competitive.  Will all souvenir shops charge the same price?  If so, what price will they charge?

35. © 2009 Pearson Addison-Wesley. All rights reserved. 19-35 When Price Is Not Competitive.  If all other shops charge p*, a firm can profitably charge p 1 = p* + ε,  where ε, a small positive number, is the shop’s price markup.  If consumers have limited information about price, an equilibrium in which all firms charge the full-information, competitive price is impossible.

36. © 2009 Pearson Addison-Wesley. All rights reserved. 19-36 Monopoly Price.  Can there be an equilibrium in which all stores charge the same price and that price is higher than the competitive price?  The monopoly price may be an equilibrium price.

37. © 2009 Pearson Addison-Wesley. All rights reserved. 19-37 Monopoly Price. When consumers have asymmetric information and when search costs and the number of firms are large, the only possible single-price equilibrium is at the monopoly price.

38. © 2009 Pearson Addison-Wesley. All rights reserved. 19-38 Solved Problem 19.2  Initially, there are many souvenir shops, each of which charges p m (because consumers do not know the shops’ prices), and buyers’ search costs are c. If the government pays for half of consumers’ search costs, can there be a single-price equilibrium at a price less than p m ?

39. © 2009 Pearson Addison-Wesley. All rights reserved. 19-39 Information About Employment Risks  Firms typically have more information than workers about job safety.  This asymmetric information may lead to less than optimal levels of safety

40. © 2009 Pearson Addison-Wesley. All rights reserved. 19-40 Information About Employment Risks  Each firm must consider how safe to make its plant.  Extra safety is costly.  Safety investments by one firm provide an externality to other firms:  That firm’s lower incidence of accidents reduces the wage that all firms in the industry must pay.  Because each firm bears the full cost of its safety investments but derives only some of the benefits, the firms underinvest in safety.

41. © 2009 Pearson Addison-Wesley. All rights reserved. 19-41 Table 19.1 Safety Investment Game

42. © 2009 Pearson Addison-Wesley. All rights reserved. 19-42 Cheap Talk  When an informed person voluntarily provides information to an uninformed person, the informed person engages in:  cheap talk - unsubstantiated claims or statements

43. © 2009 Pearson Addison-Wesley. All rights reserved. 19-43 Cheap Talk  Suppose that a firm plans to hire Cyndi to do one of two jobs.  The demanding job requires someone with high ability.  The undemanding job can be done better by someone of low ability because the job bores more able people, who then perform poorly.

44. © 2009 Pearson Addison-Wesley. All rights reserved. 19-44 Table 19.2 Employee-Employer Payoffs

45. © 2009 Pearson Addison-Wesley. All rights reserved. 19-45 Cheap Talk  The firm’s expected payoff is  if it gives her the undemanding job and

46. © 2009 Pearson Addison-Wesley. All rights reserved. 19-46 Education as a Signal  If high-ability people are more likely to go to college than low-ability people, schooling signals ability to employers

47. © 2009 Pearson Addison-Wesley. All rights reserved. 19-47 Education as a Signal  Extreme assumptions that  graduating from an appropriate school serves as the signal and  that schooling provides no training that is useful to firms  High-ability workers are θ share of the workforce, and low-ability workers are 1 − θ share.  The value of output that a high-ability worker produces for a firm is worth w h, and that of a low-ability worker is w l (over their careers).

48. © 2009 Pearson Addison-Wesley. All rights reserved. 19-48 Education as a Signal  pooling equilibrium - an equilibrium in which dissimilar people are treated (paid) alike or behave alike.  Employers pay all workers the average wage:

49. © 2009 Pearson Addison-Wesley. All rights reserved. 19-49 Education as a Signal  We assume that  high-ability individuals can get a degree by spending c to attend a school and  that low-ability people cannot graduate from the school

50. © 2009 Pearson Addison-Wesley. All rights reserved. 19-50 Education as a Signal  separating equilibrium - an equilibrium in which one type of people takes actions (such as sending a signal) that allows them to be differentiated from other types of people

51. © 2009 Pearson Addison-Wesley. All rights reserved. 19-51 Education as a Signal  In a separating equilibrium,  high-ability people pay c to get a degree and are employed at a wage of w h,  while low-ability individuals do not get a degree and work for a wage of w l.

52. © 2009 Pearson Addison-Wesley. All rights reserved. 19-52 Education as a Signal  Rearranging terms in the previous expression, we find that a high-ability person chooses to get a degree if w h − w l > c.

53. © 2009 Pearson Addison-Wesley. All rights reserved. 19-53 Pooling Equilibrium.  In a pooling equilibrium, all workers are paid the average wage.  It does not pay for the high-ability person to graduate if the benefit from graduating, the extra pay is less than the cost of schooling:

54. © 2009 Pearson Addison-Wesley. All rights reserved. 19-54 Solved Problem 19.3  For what values of θ is a pooling equilibrium possible in general? In particular, if c = $15,000, w h = $40,000, and w l = $20,000, for what values of θ is a pooling equilibrium possible?

55. © 2009 Pearson Addison-Wesley. All rights reserved. 19-55 Unique or Multiple Equilibria.  Depending on differences in abilities, the cost of schooling, and the share of high- ability workers, only one type of equilibrium may be possible or both may be possible.

56. © 2009 Pearson Addison-Wesley. All rights reserved. 19-56 Figure 19.2 Pooling and Separating Equilibria

57. © 2009 Pearson Addison-Wesley. All rights reserved. 19-57 Efficiency.  In our example of a separating equilibrium, high-ability people get an otherwise useless education solely to show that they differ from low-ability people.  Signaling changes the distribution of wages:  Instead of everyone getting the average wage, high-ability workers receive more pay than low-ability workers.

58. © 2009 Pearson Addison-Wesley. All rights reserved. 19-58 Figure 19.2 Pooling and Separating Equilibria

59. © 2009 Pearson Addison-Wesley. All rights reserved. 19-59 Efficiency. Total social output falls with signaling if signaling is socially unproductive but may rise with signaling if signaling also raises productivity or serves some other desirable purpose.

60. © 2009 Pearson Addison-Wesley. All rights reserved. 19-60 Screening in Hiring  Firms screen prospective workers in many ways.  Interviews and Tests.  Statistical Discrimination

61. © 2009 Pearson Addison-Wesley. All rights reserved. 19-61 Figure 19.3 Statistical Discrimination