Asymmetric Information L25 Asymmetric Information

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

Asymmetric Information Assumption: full information about the traded commodities What about following markets? Medical services: a doctor knows more than does the buyer. Insurance: 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” Second hand car market. Types of cars: “lemons” and “plums”. Car value Benchmark: Perfect information Gains-to-Trade Lemon Plum Seller 1000 2000 Buyer 1200 2400

Asymmetric information Lemon Plum Seller 1000 2000 Buyer 1200 2400 Asymmetric information (50% - 50%)

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

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

Adverse Selection Separating equilibrium “too many” lemons “crowd out” the plums from the market. gains-to-trade are reduced since no plums are traded Bad for plum owners Pooling equilibrium Lemon owners “hide” behind the plums Somewhat bad for plum owners

Signaling Asymmetric information bad for “good” types Incentive for high-quality sellers to credibly signal that they are high-quality Examples of signals: warranties, professional credentials, references from previous clients, costly adds, education etc.

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)

Equilibrium with signaling Signal: MBA education Managers can chose the level 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 It is a deadweight loss Q: Is there a separating equilibrium with signaling?

Credible signal Can we separate now? When? Deadweight loss (burning money) Common in real world: adds

A credible signal Can we separate now? When? 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 assume proper incentives