Asymmetric Information Perloff Chapter 19

Asymmetric Information When two parties to a transaction have different information. Adverse Selection When an informed person has an advantage through an unobserved characteristic. Eg a disproportionately large number of unhealthy people buy life insurance. Moral Hazard When an informed person has an advantage through an unobserved action. An insured car driver drives faster.

Equalising information Screening Obtaining information about hidden characteristics. Insurance. Costly. Signalling Use of public information to indicate the nature of private information. Restaurant.

Market for lemons and good cars (a) Market for Lemons (b) Market for Good Cars S L Price of a lemon, $ E Price of a good car, $ 2,000 D G 1,750 S 2 f F 1,500 D * 1,500 D * 1,250 S 1 e 1,000 D L 750 Lemon markets are an example of adverse selection. People are willing to pay £1000 for a lemon and $2000 for a good car. Reservation price of owners of good cars is $750 and that of owners of lemons is v which is less than 2000. The two values shown in b both result in an equilibrium price of 2000. If people are ignorant of whether they are selling or buying a lemon (symmetric imperfect information) the price people are prepared to sell at is less than $1375 (average of 750 and 2000) and the price people are prepared to pay is 1500 so all of the cars will again be sold. With asymmetric information two equilibrea are possible dependant on the price the sellers of good cars are willing to accept. If sellers value their cars at 1250 buyers are prepared to pay 1500 all cars are sold at 1500. I sellers of good cars value cars at 1750 buyers will soon learn that the price they are prepared to pay is insufficient to encourage the sellers of good cars to sell. Therefore the price they are prepared to pay is revised down to 1000 and the only market is the lemon market. Inefficiency results because there are people who are willing to pay the higher price required by owners of good cars yet they don’t get to pay it. 1 ,000 1 ,000 Lemons per year Good cars per year

Preventing the occurrence of lemon markets Laws Product liability laws, Consumer screening The use of a mechanic, Reputation, Third party comparisons, ‘Which’ reports, Standards and certification, Kite marks, Signalling by firms Brand names to differentiate product.

Price Discrimination Through Asymmetric Information Charge a different price according to willingness to pay. Some consumer’s may falsely believe a product is of a higher quality. Own label product.

Tourist Trap Model Pure competitive market: All firms charge the same price. A higher price results in zero demand. Imperfect information in a competitive market. Know the prices charged by shops but not specific price charged by a specific shop. Competitive price is p*. Firm can charge p*+e. e is less than cost of finding another shop.

Monopoly price in a ‘tourist trap’ Suppose all firms charge p*+e Same reasoning implies all firms can raise price to p*+2e This argument can continue to be applied until all firms charge the monopoly price. At this price further price increases result in a loss of profit. In a market where finding prices is costly the equilibrium price is the monopoly price. If firms are allowed to advertise prices so that search costs disappear the competitive price results.

Employee safety with asymmetric information Employees in safer industries pay lower wages than in unsafe. Safety statistics are reported at industry levels, not the firm level.

Lying to a potential employer? In a if cyndis ability is high and she gets an undemanding job, both payoffs to herself and the firm are low because she gets bored. This is a two stage game, if cyndis ability is high and she says so she is given demanding job, this gives both parties the highest payoff Similar thing happens if her ability is low In the second case cyndi wants the demanding job regardless of he ability. She has an incentive to lie. The firm knows this. Therefore they assume that she is equally likely to be either high or low ability. She is given the job which maximises expected payoff which is 1.5 for the demanding job and 2.5 for the undemanding. They give her the undemanding job and lose out on all the employees that are high ability.

Education as a signal Low ability people will not graduate. Have to accept lower unskilled wage. High ability people will go to college if difference between skilled and unskilled wage exceeds cost of education Two equilibrea are possible Pooling When costs of education exceed the wage differential and everyone is paid the same. Seperating When it pays to go to college.

Pooling and separating equilibrea If theta is greater than the value in 5 a pooling equilibrium is possible. Eg if c=3000 wh30000 wl20000 theta is 0.3. If wh increases to 40000 theta decreases to 0.15. As theta becomes large, the average wage approaches wh and so there is little benefit in attending university. The equation shows that when theta is small only a separating eq is possible. As it increases it crosses a threshold where the pooling eq occurs

Unique or multiple equilibrea Pooling equilibrium c, Cost per diploma, $ 20,000 c = w – w h l Pooling or separating equilibrium x y 15,000 Wh=40000, wl=20000 Below the sloped line theta(q) is less than the threshold so separating occurs. Above the line the cost of signaling is greater than the wage differential so no-one goes to uni. Between the line both are poss eg c=15000 and theta =0.5 wbar=30000 hence both wh-wl=20000>15000 And Wh-wbar=10000<15000 A government can ensure that a separating equilibrium exists by subsidising a few high ability individuals to attend uni, once the separating eq exists all high ability people wil signal. Notice also that at y, the high quality workers earn less (40000-15000) in the separating eq than in the pooling (30000). z 5,000 c q = 1 – — — — — w – w h l Separating equilibrium 1 1 1 – – 4 2 q , Share of high-ability workers