1. Asymmetric Information
L25
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