1. Lecture 8 Asymmetric Information: Adverse Selection
Microeconomics 1000
Lecture 8 Asymmetric Information: Adverse Selection

2. Market failures
A market economy delivers the efficient allocation of resources (invisible hand, I theorem of welfare economics)
However, efficiency is not guaranteed in the presence of
Market power
Externalities
Public goods
Asymmetric information

3. Asymmetric information and uncertainty
Under complete information, each agent knows the state of the world
Uncertainty means that there are many possible states of the world, and agents do not know which one actually occurs
Asymmetric information means that different agents have different information as to which state of the world will occur or has occurred

4. Asymmetric information v. uncertainty
Suppose A owns an umbrella
The value of the umbrella to A is 0 if it does not rain and 10 if it rains
B has not got an umbrella; the value of the umbrella to him is 0 if it does not rain and 16 if it rains
B believes that the probability that it may rain is 50%

5. Asymmetric information v. uncertainty
Suppose A also believes that the probability that it may rain is 50%
This is a situation of uncertainty
The expected value of the umbrella is 5 for A, 8 for B
Trade will take place at some price between 5 and 8
B eventually obtains the umbrella, which is efficient since he values it more than A

6. Asymmetric information v. uncertainty
But now suppose that A knows for sure whether it will rain or not
This is a situation of asymmetric information (A knows something that B does not know)
Will the efficient solution be achieved under these circumstances?

7. Hidden information v. Hidden Actions
In the previous example, the asymmetry concerned knowledge about the state of the world
Asymmetric information may concern the actions of some players
Adverse Selection (hidden information) v. Moral Hazard (hidden action)

8. Moral hazard
Moral hazard refers to the tendency of a person who is imperfectly monitored (e.g., an employee) to engage in dishonest or otherwise undesirable behavior.
Employers can respond to the moral-hazard problem in various ways:
Better monitoring.
High wages.
Delayed payment.

9. Moral Hazard Moral Hazard
An agent is a person who is performing an act for another person, called the principal.
The principal is a person for whom another person, called the agent, is performing some act.

10. Adverse selection
In general, the term Adverse Selection refers to any situation where some information is hidden (that is, is hold only by one agent, or a subset of agents)
To be more precise, however, the term adverse selection refers to the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uniformed party

11. The market for lemons
This theory was developed by Nobel Prize winner George Akerlof (University of Berkeley) in an article published in 1970
The title of his paper, “The market for lemons”, has become an alternative name of the theory of adverse selection under perfect competition
In American slang, a “lemon” is a bad quality second-hand car

12. The market for lemons Two types of cars, good cars and lemons
Value (reservation price) of a good car for the seller (owner): 100
Value of a bad car for the seller (owner): 20
Value (willingness to pay) of a good car for the buyer: 150
Value of a bad car for the buyer: 30
That is, buyers value both bad and good cars 50% more than sellers: there is room for trade

13. Information
Suppose there is an equal number of good and bad cars for sale
On the face of it, a bad car is indistinguishable from a good car
However, each seller knows the quality of his car
Buyers only know that the probability of getting a good car is 50%
Information is asymmetric

14. Market structure
The market is perfectly competitive: a large number of buyers and sellers, each of whom is a price taker
Suppose for simplicity that the number of buyers is larger than that of sellers, so the equilibrium price leaves the buyers with zero surplus (as will become clear, this is the assumption most favourable to the theory thaty markets work efficiently)

15. Equilibrium Suppose that both bad and good cars are offered
How much will a buyer be willing to pay?
150 x 50% + 30 x 50% = 90
So 90 should be the equilibrium price
But, at a price of 90 owners of good cars are not willing to sell!
Hence, only bad cars will be offered

16. Equilibrium
Buyers, who are uninformed but clever, anticipate that only bad cars will be offered
Hence, they will be willing to pay no more than 30
This will be the equilibrium price, and only bad cars will be traded
The gain from trade is only16.7% (= 10/60) of the total potential gain

17. Markets for lemon
Recall, adverse selection refers to the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uniformed party.
The adverse selection problem can be so serious that the market almost vanishes

18. Example
Suppose there are ten types of second-hand cars, with values (to the owners) of 100, 90, 80,…, 10
Each type equally probable (10% of the total supply)
Buyers’ valuation = sellers’ valuation + 50%
As before, owners informed but buyers uninformed

19. Example (cont’d)
Average value if all types are supplied: 55 for buyers, % 55 = 82.5 for sellers
Hence, if all types were offered, price would be 82.5
But then best quality cars not offered, only quality levels 80, 70 etc. are offered

20. Example (cont’d)
New average quality (given that cars of quality 100 and 90 are not offered): 45 for sellers, % 45 = 67.5 for buyers
The price would be 67.5
But then owners of cars of quality 80 and 70 would not offer their cars for sale
…….
Eventually, the market becomes tiny or even vanishes!

21. Examples of Adverse Selection
Insurance—People with hidden health problems are more likely to want to buy health insurance than those with good health
Credit rationing – Less trustworthy people are more likely to apply for a loan when the interest rate increases (since they know they are going to take the money and run)
In certain labor markets, if a firm reduces the wage it pays, high productivity workers tend to quit.

22. Adverse selection with market power
Second-degree price discrimination: firms price their product (or choose the quality of their products) so as to induce consumers to self-select

23. Price discrimination
Suppose there are two consumers, who may buy 0, 1 or 2 units of a product
A values (is willing to pay) £ 7 the first unit, and £ 4 the second unit
B values £ 6 the first unit, and £ 2 the second unit
There is a monopolistic firm
The unit cost is c = 2

24. Price discrimination
If the monopolist had complete information, it would charge £ 11 for 2 units to consumer A, and £8 for 2 units to consumer B (total profit 12)
Suppose the monopolist knows that 50% of the consumers are of type A and 50% of type B, but does not know who is which type
Each consumer, however, knows his type
(Asymmetric information)

25. Non discrimination
If the monopolist charges a uniform price for each unit, he would sell 1 unit when p = 7, 2 units when p = 6, 3 units when p = 4 and 4 units when p = 3
Profit maximizing price is p = 6, the total profit is 8

26. Price discrimination
Another possibility for the monopolist is to sell packages of 2 units at a price of 8
Total profit = (8 – 4 ) x 2 = 8
The optimal strategy, however, is as follows:
Sell single units at a price of 6, and packages of two units at a price of 10
Type A consumers will buy the package, type B only one unit
Total profit (6 – 2) + (10 – 4) = 10

27. Quantity discounts This is an example of quantity discounts
Quantity discounts are a form of price discrimination: the price of the second unit you purchase is different (lower) then the price of the first unit

28. Signaling to Convey Private Information
In the previous analysis, the uninformed party was supposed to offer the contract (or menu of contracts)
When the informed party proposes the contract, we are in the framework of signaling games
Signaling refers to an action taken by an informed party to reveal private information to an uninformed party.
warranties

29. Asymmetric Information and Markets
The study of asymmetric information gives us new reason to be wary of markets.
When some people know more than others do, the market may fail to put the resources to their best uses.

30. Asymmetric Information and Public Policy
Although asymmetric information may call for government action, three facts complicate the issue:
Private markets can sometimes deal with information asymmetries on their own
The government rarely has more information than the private parties.
The government itself is an imperfect institution