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 u Assumption: full information about the traded commodities u What about following markets? 1.Medical services: a doctor knows more than does the patient. 2.Insurance: buyer knows more about his riskiness than does the seller. 3.Used cars: a car’s owner knows more about it than does a potential buyer u Problem: asymmetric information

Today u Q: how does asymmetric information affect the functioning of a market? u Important phenomena  adverse selection (hidden information)  signaling  moral hazard (hidden action)

Market for “lemons” u Second hand car market. u Types of cars: “lemons” and “plums”. u Benchmark: Perfect information u Gains-to-Trade (50% - 50%) LemonPlum Seller Buyer

Asymmetric information u Asymmetric information (50% - 50%) u Gains-to-trade and BS, SS LemonPlum Seller Buyer

Separating equilibrium u Asymmetric information (, ) LemonPlum Seller Buyer

Pooling equilibrium u Asymmetric information (, ) u Gains-to-trade BS and SS LemonPlum Seller Buyer

Adverse Selection Separating equilibrium u “too many” lemons “crowd out” the plums from the market. u gains-to-trade are reduced since no plums are traded u Bad for plum owners Pooling equilibrium u Lemon owners “hide behind” the plums u Somewhat bad for plum owners u Pareto efficiency Probability of “bad type” is high: compulsory insurance

Signaling u Asymmetric information bad for “good” types u Incentive: Credible signal of high-quality u Examples of signals: warranties, professional credentials, references from previous clients, costly adds, education etc.

Signaling (in Labor Market) u Two types of managers - high-ability manager has productivity (a plum) - low-ability manager has productivity (a lemon) u Fraction of high-productivity managers u Competitive markets u Benchmark: No signal (pooling)

Equilibrium with signaling Signal: MBA education u Managers can chose the level of education Cost of education (MBA) u For high-ability worker education costless u For low-ability worker Benefit of education u MBA has no effect on workers’ productivities u Talent not observed but MBA diploma yes - signal u It is a deadweight loss u Q: Is there a separating equilibrium with signaling?

(Non) Credible signal u Can we separate with e=2?

(Non) Credible signal u Credibility condition

A credible signal u Can we separate now? u Signal more costly to low type u Deadweight loss (burning money) u Common in real world: adds

Moral Hazard (hidden action) u With full car insurance are you more likely to leave your car unlocked? u With fixed hourly wage is your effort at work reduced? u Moral hazard is a reaction to incentives to increase the risk of a loss u A consequence of asymmetric information (hidden action).

Moral hazard u Perfect information: full insurance u Asymmetric information: -partial insurance -contract that depends on output To assume proper incentives