Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. ASYMMETRIC INFORMATION 1. Definition of asymmetric information 2. Sources of asymmetric information 3. Hidden actions and moral hazard 4. Hidden characteristics and adverse selection 5. Signaling and screening

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 1. DEFINITION “I know more than you know” Many times in life, one person know more about what is going on than another. A difference in access to relevant knowledge is called asymmetric information

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Examples of AI 1. Worker knows more than his employer about how much effort he works. 2. A seller of used car knows more than the buyer about the car’s conditions; or clean and unclean vegetables.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 2. Sources of asymmetric information AI comes from hidden actions or characteristics u Hidden actions e.g. Worker knows more than his employer about how much effort he works. u Hidden characteristics e.g. A seller of used car knows more than the buyer about the car’s conditions.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 3. Hidden action and Moral Hazard People knows less called principal (employer) People knows more called agent (worker) Hidden action leads to the problem of Moral Hazard Moral hazard: Tendency of a person who is imperfectly monitored engage dishonest or otherwise undesirable behavior. Moral hazard refers to “immoral behavior” of the agent

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 3.Hidden action and Moral Hazard (cont.) Principal tries ways to encourage the agent to act more responsibly: u Better monitoring: Video record, … u High wage: Efficiency wage u Delayed payment: Year-end-bonus

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 4. Hidden characteristics and adverse selection Hidden characteristics leads to adverse selection Adverse selection arises when one person knows more about the attributes of a good than another and thus the uninformed person runs the risk of being sold a good of low quality Seller of used car knows more than the buyer, the buyer avoids buying used car or buying at low price.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 4. Hidden characteristics and adverse selection (cont.) Worker knows his ability more than the employer, employer chooses to pay above- equilibrium wage. Buyer of health insurance knows more about his own health problem than the company, the price reflect the costs of a sicker-than-average person, person in average health is discouraged from buying by the high price.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5. Signaling and screening Markets respond to the AI by signaling and screening u Signaling: Informed party takes action to reveal private information to a uninformed party Examples: Advertising Graduates show degree

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. GIFTS as signals u Does he really love her? He knows but she does not. u Boy signals his love to the girlfriend by giving gifts for her birthday. u The Gift for a girlfriend is cash or in- kind?

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Signaling and screening (cont.) Screening: Uninformed party take action to reveal private information Examples u Car buyer asks to check the car, seller refuses or not  lemon or not lemon will be revealed u Car insurance company has two policies (high premium without deductible and low premium with deductible)  it will classify safe and risk drivers