1. Asymmetric Information
L25
Asymmetric Information

2. Road map 1) Consumers choice 2) Equilibrium, Producers
(Pareto efficiency)
3) Market Failures
- fixed cost: monopoly and oligopoly
- externalities and public goods
- asymmetric information

3. Asymmetric Information
Assumption: full information about the traded commodities
What about following markets?
Medical services: a doctor knows more than does the buyer.
Insurance: 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” Second hand car market.
Types of cars: “lemons” and “plums”.
Car value
Benchmark: Perfect information
Gains-to-Trade
Lemon
Plum
Seller
1000
2000
Buyer
1200
2400

6. Asymmetric information
Lemon
Plum
Seller
1000
2000
Buyer
1200
2400
Asymmetric information (50% - 50%)

7. Separating equilibrium
Lemon
Plum
Seller
1000
2000
Buyer
1200
2400
Asymmetric information ( , )

8. Pooling equilibrium Asymmetric information ( , ) Lemon Plum Seller
1000
2000
Buyer
1200
2400
Asymmetric information ( , )

9. Adverse Selection Separating equilibrium
“too many” lemons “crowd out” the plums from the market.
gains-to-trade are reduced since no plums are traded
Bad for plum owners
Pooling equilibrium
Lemon owners “hide” behind the plums
Somewhat bad for plum owners

10. Signaling Asymmetric information bad for “good” types
Incentive for high-quality sellers to credibly signal that they are high-quality
Examples of signals: warranties, professional credentials, references from previous clients, costly adds, education etc.

11. Signaling (in Labor Market)
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)

12. Equilibrium with signaling
Signal: MBA education
Managers can chose the level 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
It is a deadweight loss
Q: Is there a separating equilibrium with signaling?

13. Credible signal Can we separate now? When?
Deadweight loss (burning money)
Common in real world: adds

14. A credible signal Can we separate now? When?
Deadweight loss (burning money)
Common in real world: adds

15. 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).

16. Moral hazard Perfect information: full insurance
Asymmetric information:
partial insurance
contract that depends on output
To assume proper incentives