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Asymmetric Information

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Presentation on theme: "Asymmetric Information"— Presentation transcript:

1 Asymmetric Information
L24 Asymmetric Information

2 Market Efficiency 1) Competitive markets are efficient
2) Market failures a) market power b) externalities c) public goods d) asymmetric information

3 Asymmetric Information
Assumption: full information about the traded commodities What about following markets? Medical services: a doctor knows more than does a patient. Insurance: a 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

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

5 Market for “lemons” Market for used cars (Akerlof 1970)
Types of cars: “lemons” and “plums”. Proportion: 50% - 50% TPS (Total Potential Surplus) Lemon Plum Seller 1000 2000 Buyer 1200 2400

6 Benchmark: perfect information
Prices (halfway): Buyer’s and seller’s surplus TPS and BS+SS? Lemon Plum Seller 1000 2000 Buyer 1200 2400

7 Asymmetric information
Lemon Plum Seller 1000 2000 Buyer 1200 2400 Asymmetric information (50% - 50%) TPS and BS, SS Separating Equilibrium

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

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

10 Adverse Selection Separating equilibrium
Lemons “crowd out” plums from the market. Surplus is reduced since no plums are traded Very bad for plum owners Pooling equilibrium Lemon owners “hide behind” the plums Somewhat bad for plum owners Pareto efficiency (full surplus) Probability of “bad type” is high: compulsory insurance

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

12 Signaling (Spence, labor markets)
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)

13 Equilibrium with signaling
Signal: MBA education Years 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 Q: Is there a separating equilibrium with signaling?

14 (Non) Credible signal Is MBA a credible signal with e=2? Suppose

15 Credible signal Credibility condition

16 A credible signal Can we separate now? Same credibility condition
Deadweight loss (burning money) Common in real world: adds

17 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).

18 Moral hazard Perfect information: full insurance
Asymmetric information: partial insurance contract that depends on output To induce proper incentives


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