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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.