Chapter 18 Asymmetric Information

Slides:



Advertisements
Similar presentations
© 2010 Pearson Addison-Wesley. Decisions in the Face of Uncertainty Tania, a student, is trying to decide which of two alternative summer jobs to take.
Advertisements

Uncertainty and Information CHAPTER 19 C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to 1 Explain.
Asymmetric Information
Labor Market Discrimination Troy Tassier Fordham University.
Chapter 37 Asymmetric Information In reality, it is often the case that one of the transacting party has less information than the other. Consider a market.
Chapter 14 Markets with Asymmetric Information. Chapter 17Slide 2 Topics to be Discussed Quality Uncertainty and the Market for Lemons Market Signaling.
Factor Markets and the Distribution of Income
© 2009 Pearson Education Canada 20/1 Chapter 20 Asymmetric Information and Market Behaviour.
Slide 1  2002 South-Western Publishing An assumption of pure competition was complete knowledge of all market information. But knowledge can be unevenly.
© 2013 Pearson. How do you avoid buying a lemon?
Adverse Selection Asymmetric information is feature of many markets
Chapter 11 Game Theory and Asymmetric Information
CHAPTER 6 The Medium Run CHAPTER 6 Prepared by: Fernando Quijano and Yvonn Quijano Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall.
L25 Asymmetric Information. Structure of the course 1) Consumers choice 2) Equilibrium, Producers (Pareto efficiency) 3) Market Failures - fixed cost:
Asymmetric Information ECON 370: Microeconomic Theory Summer 2004 – Rice University Stanley Gilbert.
Sample Questions Exam 4 Chapters 16, 17, 9, & 7. Price Discrimination Price discrimination Charging different prices to different customers for the same.
Copyright©2004 South-Western 19 Earnings and Discrimination.
Chapter 9 THE ECONOMICS OF INFORMATION Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved. MICROECONOMIC THEORY BASIC.
Wrapping UP Insurance Let’s Review Moral Hazard With health insurance, the amount of expenditures may depend on whether you have insurance. Suppose that.
Copyright©2004 South-Western 19 Earnings and Discrimination.
Earnings and Discrimination Chapter 19 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the.
© 2007 Thomson South-Western. Earnings and Discrimination Differences in Earnings in the United States Today –The typical physician earns about $200,000.
1 Chapter 9 Knowledge and Information In this chapter we want to see what happens in a market when the amount of information participants have is different.
Lectures Section Seven: Market Failure Introduction to Microeconomics (L11100)
CHAPTER 17 Uncertainty and Asymmetric Information © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Microeconomics 9e by Case, Fair.
Labor Markets and Earnings Economics 230 J.F. O’Connor.
CHAPTER 8: SECTION 1 A Perfectly Competitive Market
Industrial Economics Fall INFORMATION Basic economic theories: Full (perfect) information In reality, information is limited. Consumers do not know.
Asymmetric Information and Agency. Overview and Background Traditional models of demand side assume that individuals have complete information about prices.
© 2005 Worth Publishers Slide 12-1 CHAPTER 12 Factor Markets and the Distribution of Income PowerPoint® Slides by Can Erbil and Gustavo Indart © 2005 Worth.
Copyright©2004 South-Western 19 Earnings and Discrimination.
Imperfect Information: Quality Uncertainty and the Market for Lemons
Economics of Information Asymmetric Information: Adverse Selection and Moral Hazard Chapter 17.
Chapter 37 Asymmetric Information. Information in Competitive Markets In purely competitive markets all agents are fully informed about traded commodities.
Asymmetric Information
Chapter 17 Markets with Asymmetric Information. ©2005 Pearson Education, Inc. Chapter 172 Introduction We can see what happens when some parties know.
Any Questions from Last Class?. Chapter 17 The Problem of Moral Hazard COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson,
L25 Asymmetric Information. Road map 1) Consumers choice 2) Equilibrium, Producers (Pareto efficiency) 3) Market Failures - fixed cost: monopoly and oligopoly.
Building and Managing Human Resources
McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All rights reserved. 7-1 Defining Competitiveness Chapter 7.
Asymmetric Information
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. ASYMMETRIC INFORMATION 1. Definition of asymmetric information 2. Sources of.
Chapter 5 Compensating Wage Differentials Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.
Copyright © 2014 Pearson Canada Inc. Chapter 8 AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE Mishkin/Serletis The Economics of Money, Banking, and Financial.
© 2010 W. W. Norton & Company, Inc. 37 Asymmetric Information.
Asymmetric Information
Chapter 16: Information, Market Failure, and the Role of Government 1 of 37 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics.
MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 10 th Edition, Copyright 2009 PowerPoint prepared by.
Presented By: Ahmed Mujtaba Ahmed Raza Annan Saeed Dilawar Qazi
1 Transaction Costs, Imperfect Information, and Market Behavior Chapter 14 © 2006 Thomson/South-Western.
Monopoly and Public Policy. Welfare Effects of Monopoly ▫By holding output below the level at which marginal cost is equal to the market price, a monopolist.
C. Bordoy UWC Maastricht Market Failure HL material HL material (Tragakes, 2012, pp )
Chapter Nineteen Asymmetric Information. © 2009 Pearson Addison-Wesley. All rights reserved Topics  Problems Due to Asymmetric Information.  Responses.
McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc. All rights reserved. 7-1 Defining Competitiveness Chapter 7.
20 UNCERTAINTY AND INFORMATION © 2012 Pearson Education.
McGraw-Hill/Irwin Copyright © 2004 by the McGraw-Hill Companies, Inc. All rights reserved. Chapter 2 Objective and Risk Management.
19 Earnings and Discrimination. Differences in Earnings in the United States Today – The typical physician earns about $200,000 a year. – The typical.
Chapter Thirty-Six Asymmetric Information. Information in Competitive Markets u In purely competitive markets all agents are fully informed about traded.
Compensating Wage Differentials
THE ECONOMICS OF INFORMATION
Earnings and Discrimination
Lecture 8 Asymmetric Information: Adverse Selection
Earnings and Discrimination
Factor Markets and Vertical Integration
Asymmetric Information
Markets with Asymmetric Information
Asymmetric Information
Earnings and Discrimination
Presentation transcript:

Chapter 18 Asymmetric Information The buyer needs a hundred eyes, the seller not one. George Herbert (1651)

Chapter 18 Outline Challenge: Dying to Work 18.1 Problems Due to Asymmetric Information 18.2 Responses to Adverse Selection 18.3 How Ignorance About Quality Drives Out High-Quality Goods 18.4 Market Power from Price Ignorance 18.5 Problems Arising from Ignorance When Hiring Challenge Solution

Challenge: Dying to Work Background: Rational people who fear danger agree to work in dangerous jobs only if those jobs pay a sufficiently higher wage than less-risky alternative jobs. Prospective employees often do not know the injury rates at individual firms but may know the average injury rate over an entire industry. Questions: Does such a situation cause firms to underinvest in safety? Can government intervention overcome such safety problems?

18.1 Problems Due to Asymmetric Information Asymmetric information exists when one party to a transaction knows a material fact that the other party does not. Example: used car salesperson knows the quality of the car and the buyer does not. The more informed party may engage in opportunistic behavior, which is taking advantage of someone when circumstances permit. Opportunistic behavior leads to market failures. Two major types of opportunistic behavior: Adverse selection Moral hazard

18.1 Problems Due to Asymmetric Information Adverse selection is opportunism characterized by an informed person’s benefitting from trading with a less-informed person who doesn’t know about an unobserved characteristic of the informed person. Example: people who buy life insurance policies are better informed about their own health than insurance companies are. Moral hazard is opportunism characterized by an informed person’s taking advantage of a less-informed person through an unobserved action. Example: insured people may engage in risky behaviors that increase the probability of claims against the insurance company.

18.2 Responses to Adverse Selection Adverse selection creates a market failure by reducing the size of a market or eliminating it. Example: Insurance companies have to charge higher rates due to adverse selection, thus, fewer people can afford insurance. Two main methods for solving the adverse selection problem: Restricting opportunistic behavior Equalizing information

18.2 Responses to Adverse Selection Controlling Opportunistic Behavior Adverse selection can be prevented if people have no choice. Examples: A government can provide universal health insurance coverage Firms provide health insurance benefits to all employees Many states require drivers to carry auto insurance Equalizing Information An uninformed person may engage in screening to determine information held by informed people (e.g. test-driving a car) An informed party may engage in signaling to send information to a less-informed person (e.g. firm distributing favorable report on its product by an independent testing agency)

18.3 How Ignorance About Quality Drives Out High-Quality Goods Consumers often have trouble determining the quality of goods and services. Consumer ignorance about quality leads to less-efficient use of resources than would occur if everyone were perfectly informed. Example: Used-car markets Owners of lemons, low-quality cars, are more likely to sell their cars than owners of high-quality cars. Creates an adverse selection problem; too few high-quality cars in the used-car market.

18.3 Markets for Lemons and Good Cars If good car owners’ reservation price is high enough, only lemons will be sold.

18.3 How Ignorance About Quality Drives Out High-Quality Goods If both sellers and buyers know the quality of all used cars before any sales occur: all the cars, lemons and good, are sold good cars sell for a higher price than lemons this market is efficient because the goods go to the people who value them the most. In our lemons example, we assumed that sellers are unable to alter the quality of the used car. What if firms are able to vary the quality of their products?

18.3 How Ignorance About Quality Drives Out High-Quality Goods If firms are able to vary the quality of their products, but consumers can’t identify high-quality goods before they purchase: consumers pay the same price for all goods (regardless of quality) producers of high-quality goods do not capture the benefits from raising the quality of their product. the incentive to produce high-quality is reduced or eliminated. Stated another way, the social value of raising product quality is greater than the private value.

18.3 How Ignorance About Quality Drives Out High-Quality Goods How might we avoid problems stemming from consumer ignorance? Laws to prevent opportunism, like product liability laws, may protect consumers. Consumers can obtain reliable information about quality through screening. Some organizations publish expert third-party comparisons of brands (e.g. Consumer Reports) Government, consumer groups, or industry groups can provide information based on standards and certification. Producers of high-quality goods can use signaling to inform consumers about their products’ superiority over rivals’.

18.4 Market Power from Price Ignorance Consumer ignorance about quality not only has potential to keep high-quality goods out of the market. Consumer ignorance about price variation across firms gives firms market power. Firms thus have incentive to make it difficult for consumers to collect pricing information.

18.4 Market Power from Price Ignorance Tourist-Trap Model Assume you’re a tourist in a small town Tour bus has stopped on a street crowded with souvenir shops You have no time to compare prices because the bus is leaving Normally, the close proximity of so many shops selling similar souvenirs would result in competitive prices. Consumers’ limited information about prices (and the lack of incentive to gain information since you won’t likely return) gives souvenir shops market power.

18.5 Problems Arising from Ignorance When Hiring What kinds of asymmetric information problems plague labor markets? Prospective employees may have less information than firms do about working conditions. Firms may have less information about potential employees’ abilities than potential workers do. We examine models of screening and signaling more closely to see how workers and firms reduce information asymmetries and increase welfare in labor markets.

18.5 Cheap Talk An informed person who voluntarily provides information to an uninformed person may make unsubstantiated claims or cheap talk. Cyndi knows her ability (high or low) and the firm wants to match her ability to the level of ability demanded on the job.

18.5 Education as a Signal Although Cyndi’s cheap talk in the previous example resulted in assigning her the appropriate job, she may instead face incentives to lie about her ability. Cyndi wants demanding job regardless of her ability

18.5 Education as a Signal Why go to college? Obtain valuable training that will result in a better job. Obtain diploma to signal your ability to employers, which results in a better job. Assumptions of the signaling model: Schooling provides no useful training and only serves as a signal. High-ability workers are share of the workforce; low-ability workers are 1 – share. High-ability workers are worth wh to the firm; low-ability workers are worth wl and will pay workers these marginal products.

18.5 Education as a Signal If employers can’t directly determine a worker’s skill level, two types of equilibria are possible: Pooling equilibrium: dissimilar people are paid alike or behave alike. All workers are paid the average wage: Separating equilibrium: dissimilar people are paid differently and behave differently. Successful signal causes high-ability workers to receive wh and low-ability workers to receive wl.

18.5 Education as a Signal If schooling is very costly, only a pooling equilibrium is possible. If there are few high-ability people, only a separating equilibrium is possible.

18.5 Education as a Signal In a separating equilibrium, high-ability people get an otherwise useless education to signal that they differ from low-ability people. In this extreme example, education is socially inefficient. It is costly and would be more efficient to find a cheaper way of sending the same signal. This inefficient expenditure on education is due to asymmetric information.

18.5 Screening in Hiring Firms screen prospective workers in various ways: Hire based on characteristics believed to be correlated with ability, some of which are easily observable in an interview (e.g. how a person dresses or speaks). Hire based on performance on a test, which may or may not accurately measure skills required on the job. Some employers engage in statistical discrimination, which is hiring based on the belief that people of a certain age, gender, race, religion, or ethnicity have a higher ability than others on average.

18.5 Screening in Hiring This employer hires only people of Race 2. Actions may be based on true differences rather than racism, but still harmful to people of Race 1.

Challenge Solution Firms decide how much to invest in workplace safety and extra safety is costly. Workers must be compensated (with higher wages) for less safe work environments, so a firm that improves workplace safety can pay lower wages. If one firm invests in more safety, it can pay lower wages and so can all firms in the industry. Result stems from workers only knowing about industry-level safety rather than firm-level safety.

Challenge Solution A firm bears the full cost of safety investments, but only derives some of the benefits. This leads to underinvestment in safety by all firms in industry. Prisoners’ dilemma safety investment game: But if government or union collects and distributes firm-specific information, then firms may invest.