Microeconomics 2 John Hey

Asymmetric Information The seller of the good knows more about its quality than the buyer.. Perhaps the market does not exist … …or is inefficient. Perhaps sellers need to signal the quality. Perhaps that is why you are at university? This lecture examines: the market for lemons; moral hazard; adverse selection; signalling and reputation.

A simple example: the market for used cars Two types: lemons and plums (each 50%). Suppose that buyers cannot tell the difference. Reservation prices: Seller of a plum: 2000 Seller of a lemon: 1000 Buyer of a plum (recognised as such): 2400 Buyer of a lemon (recognised as such): What will happen if a buyer cannot can tell whether a car for sale is a plum or a lemon? (In the book I use different numbers but the argument is the same.)

A more complicated market Where there is a continuum of quality. Supply increases with the price, as does the quality. There are two effects of the price on demand: the usual – an increase in the price causes a fall in demand; and an indirect effect through the rising quality pushing up the demand for the good. Let us go to Maple...

Insurance market If the insurance company knows the probability of an accident… …there is not a problem. But the existence of insurance changes the probability (moral hazard)– or the insurance company does not know the probability (adverse selection) – there is a problem. It may be possible to solve this second problem with a separating equilibrium.

Other methods Guarantees Reputation. Experience. Signals. Usually we have to have repetitions, Note the high prices and low quality in tourists markets.

Signaling Two kinds of workers: unable (1) and able (2) with marginal productivities a 1 and a 2. (a 1 <a 2 ). Propn. b able. If distinguishable, firm pays a 1 to unable and a 2 to able. If not distinguishable, firm offers wage (1-b)a 1 +b a 2. OK? Consider education e 1 and e 2 with costs c 1 e 1 and c 2 e 2. Suppose c 2 <c 1 – it is less costly/easier for the able. *** Suppose e* is such that (a 2 -a 1 )/c 1 < e* < (a 2 -a 1 )/c 2 (which must be possible) Firm pays a 2 to those with education e*, and a 1 to those with education 0. The unable choose e=0; the able choose e=e*. (Why?) Is this an equilibrium? Is this why you are at University?

Why are you here? …to learn? …to have fun? …to avoid serious work (for the moment)?...because you do not know what you want out of life? …to get a signal (your degree, your mark) of your quality? To be useful such a signal must be informative: the higher the mark the better the student. That is why I examine this module the way that I do. My exams are not tests of memory they are tests of ability/understanding.

Lecture 34 Goodbye!