Asymmetric Information L25 Asymmetric Information

Market Efficiency 1) Competitive markets are efficient 2) Market failures a) market power b) externalities c) public goods d) asymmetric information

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 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 phenomena adverse selection (hidden information) signaling moral hazard (hidden action)

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

Benchmark: perfect information Prices (halfway): Buyer’s and seller’s surplus TPS and BS+SS? Lemon Plum Seller 1000 2000 Buyer 1200 2400

Asymmetric information Lemon Plum Seller 1000 2000 Buyer 1200 2400 Asymmetric information (50% - 50%) TPS and BS, SS Separating Equilibrium

Separating equilibrium Lemon Plum Seller 1000 2000 Buyer 1200 2400 Asymmetric information ( , )

Pooling equilibrium Asymmetric information ( , ) Efficient outcome Lemon Plum Seller 1000 2000 Buyer 1200 2400 Asymmetric information ( , ) Efficient outcome

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

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 (Spence, labor markets) 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)

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?

(Non) Credible signal Is MBA a credible signal with e=2? Suppose

Credible signal Credibility condition

A credible signal Can we separate now? Same credibility condition Deadweight loss (burning money) Common in real world: adds

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 induce proper incentives