Microeconomics

Session 19-20
Adverse Selection
 QUALITY UNCERTAINTY AND THE MARKET
FOR LEMONS

● asymmetric information Situation in which a

buyer and a seller possess different information
about a transaction – hidden information and hidden
action.

Market for Used Cars (George Akerlof

[1970]; Nobel Prize (2001))
 Market

Low quality car High quality

(Lemon) car (Plum)

Value to seller 180,000 280,000

Value to buyer 200,000 300,000

Proportion of
0.50 0.50
total cars
• Expected Value of a Car to the buyer is
0.50 × 200,000 + 0.50 × 300,000
= 250,000

• Only Low Quality cars will come to market

at that price!

• There remains no market for High Quality

cars.
 QUALITY UNCERTAINTY AND THE MARKET
FOR LEMONS

The Market for Used Cars

The lemons problem: With asymmetric information,
low-quality goods can drive high-quality goods out
of the market.

Implications of Asymmetric Information

Adverse Selection

● adverse selection: Form of market failure

resulting when products of different qualities are
sold at a single price because of asymmetric
information, so that too much of the low-quality
product and too little of the high-quality product
are sold.
 QUALITY UNCERTAINTY AND THE MARKET
FOR LEMONS
Implications of Asymmetric Information
The Market for Insurance

People who buy insurance know much more about

their general health than any insurance company can
hope to know, even if it insists on a medical
examination.
As a result, adverse selection arises, much as it
does in the market for used cars.

The Market for Credit

Borrowers know more about their credit risk (default
probabilities) than lenders.
WHAT TO DO ABOUT ADVERSE
SELECTION?
 Use publicly available relevant information.
 Legally mandate information.
 Certification by independent bodies.
 Provide information voluntarily – signaling
equilibrium
 In signaling equilibrium the informed party
takes the initiative to send a signal to the
uninformed party.
 Signaling Equilibrium
• Two key points about this sort of equilibrium:
– 1. The signal must be more costly for low quality car
owners than for high quality car owners, more costly
enough that low quality car owners are unwilling to
send the signal, even if that would fetch a price equal
to high quality cars.

– 2. The signal cannot be so expensive, relative to the

value of the cars to the buyers, that even owners of
high quality cars are unwilling to send it.
 Warranty
• A five month warranty costs
– 30,000 for a Plum Seller
– 140,000 for a Lemon Seller

• The warrantee is valued at

– 25,000 for a buyer
 Signaling Equilibrium
• Cars with 5 month warranty costs 325,000
– Plum owners make a profit of 325,000 –
280,000 – 30,000 = 15,000
– Lemon owners make a profit of 325,000-
180,000 – 140,000 = 5,000
• Cars without warranty costs 200,000
– Plum owners make a profit of 200,000 –
280,000 – Zero = – 80,000
– Lemon owners make a profit of 200,000-
180,000 – Zero = 20,000
 Signaling Equilibrium

• Job market signaling via education (Michael Spence (1973);

Nobel prize (2001)).

• Education does nothing to increase one’s productivity, but it

signals the current productivity level of the workers.

• It is more costly for low productivity workers to attain a certain

level of education than for high productivity workers.

• In equilibrium, only high productivity workers obtain more

education than low productivity workers and thus earn higher
wages.
 MARKET SIGNALING

Job market signaling does not

end when one is hired. This is
especially true for workers in
knowledge-based fields such as
engineering, computer
programming, finance, law,
management, and consulting.
Given this asymmetric information, what policy should
employers use to determine promotions and salary
increases? Workers can often signal talent and productivity
by working harder and longer hours.
Employers rely increasingly on the signaling value of long
hours as rapid technological change makes it harder for
them to find other ways of assessing workers’ skills and
productivity. The worker will know more about his abilities
than the employer.
 Homework
• Page 591, Chapter 17, Exercise 9
Moral Hazard
MORAL HAZARD

• Moral hazard exists when the unobserved actions of

one party influences the gains from trade of the
other party – hidden action.

• Principal-agent problem:
– Two actors, the principal and the agent.
– The gain from the trade to the principal depends on the
unobservable action taken by the agent.
– Actions favorable to the principal are expensive for the
agent to undertake.
EXAMPLES OF PRINCIPALS AND AGENTS

• Employer, employee
• Insurer, insured
• Shareholders, management
• Lender, borrower
 What if?

• If actions were observable and

enforceable, the principal would
specify the action in the contract.
 THE CHALLENGE IN PRINCIPAL-AGENT
PROBLEMS
• If agent were risk neutral, the principal could
let the agent bear all the consequences of the
action.
• Hence, principals must trade off risk-sharing
against motivation. The key is to find a
balance - an equilibrium.
EXAMPLES OF CONTRACTS BETWEEN
PRINCIPALS AND AGENTS
• Employers pay employees bonus.
• Insurers make the insured pay the first
deductible.
• Shareholders want the management to
hold a significant amount shares.
• Lenders hold collateral from the borrower.
 Ellinor Ostrom, Contract and
Institution
• Not all details of a contract can be noted
down.
• Over time, human beings tended to draw
up sensible rules
• Polycentricism is the right way to allocate
sensible resources.
Thank You