Information Economics Consider the following variants on the game of poker: The Certainty Game – 5 cards dealt face up so that all players can see them The Imperfect Information Game – 3 cards dealt face up and 2 face down to each player The Imperfect & Asymmetric Information Game – 3 cards dealt face up and 2 cards dealt face down to each player – each player allowed to look at their own face down cards

Information Economics In the first game there is little/no incentive to bet In the second game each player is faced with imperfect but symmetric information. Some players may be better at judging how the unseen cards may add value to the hand so there is a little scope for skill and betting becomes more likely

Information Economics In the third game each player has private information Imperfect & Asymmetric information creates scope for strategic play Bluffing & Misleading signals through the use of body language & betting behaviour

Information Economics Some transactions in markets & organizations may feature full information Many more feature a degree of asymmetric & imperfect information Hidden information Hidden action

Hidden Information Occurs when one party to a transaction has more information than the other parties about some exogenous fact relevant to the transaction Examples include life insurance and Akerlofs market for lemons (2 nd hand cars) There is an incentive for pre-contract (ex-ante) opportunism which induces adverse selection

Hidden Information in Markets Originated in insurance markets Asymmetric information between the insurer and the insured For medical insurance individuals know more about their health than the insurer Individuals have a better idea of whether insurance is a good deal Insurers tend to end up insuring bad risks – adverse selection

Medical Insurance Cost of heart by-pass operation is constant at c The size of the population is N The number of operations performed per annum is n If everyone was insured: Pr ave =n/N

Medical Insurance If everyone insured the average pay-off would be: Pr ave =c If the insurer set the premium equal to c he would break even This presumes everyone takes out the insurance What if they do not?

Medical Insurance Assume all individuals are risk-neutral and that individuals have better information about their health than the insurers Pr i is the individuals assessment of the probability of their making a claim – it is not known by insurers

Medical Insurance The individuals expected pay-off is: Pr i x c The individual will opt for the medical insurance iff: Pr i x c > Pr ave x c Pr i > Pr ave

Medical Insurance Only those with a greater than average risk will choose to insure Under this scenario the insurer makes a loss Insurer can raise premium but this forces more individuals not to insure Ultimately premiums are raised to the level where no-one insures This is the adverse selection problem

Medical Insurance In practice individuals have different attitudes to risk Also many do not know precisely their own level of risk

Akerlofs Market for Lemons 2 second hand cars Some information is readily ascertainable by both sides to any potential transaction (buyer & seller) Some information is asymmetrically distributed – it is known by the seller but not by the potential buyer

Akerlofs Market for Lemons The value of a good second-hand car is £10,000 The value of a lemon is £5,000 Assume that 50% of cars are good and 50% are lemons The market price will be £7,500

Akerlofs Market for Lemons Owners of lemons will be eager to sell their cars on the open market Owners of good cars will not Over time this will exert downwards pressure on price and eventually only lemons will be supplied Trade in good cars will disappear

Akerlofs Market for Lemons Trade between family & friends The importance of guarantees Ex-ante monitoring expenditure by the potential buyer – e.g. A.A. checks Reputation of dealers

Hidden Information in Organizations Consider an employee applying for a job elsewhere in the same company Requires a reference from current boss who has the best information Reference writer will highly praise bad employees to get rid of them Reference writer will be lukewarm about good employees to keep them

Reducing the Impact of Hidden Information Market Segmentation Self-selection Increase Monitoring Forced risk pooling Internalization

Hidden Action (Moral Hazard) Having entered into a contract one party is unable to observe the behaviour of the other party who may then have an incentive to engage in post-contract opportunism In Markets - Insurance In Organizations - Shirking

Reducing the Impact of Hidden Action Monitoring Incentive Pay