Microeconomics Patrice De Micco

Information asymmetry

Exercises

1) A firm is considering hiring a worker whose ability is a hidden characteristic. The firm only knows that the
worker has high ability (type H) with probability p and low ability (type L) with probability 1 – p. By hiring a
high-ability worker the firm obtains a revenue of 2000 euros, while hiring a low-ability worker the revenue is
only 1000. If the firm hires the worker and pays him a wage W, the worker’s payoff is W. Otherwise, the
worker’s payoff is 1200, his reservation wage. The bargaining power is entirely in the hands of the firm, that
is, it is the firm who proposes a contract to the worker.

a) If the worker’s ability were observable, which contract would the firm offer?

b) Assume now that the worker’s ability is not observable. Which contract will the firm offer? Is the resulting
allocation Pareto efficient?

c) How would your answer to point b) change, if the firm could offer a wage depending on the task performed
by the worker? Assume here that p = 1/2 and that there are two tasks, an easy task not involving any disutility
for the worker and a more difficult task involving a disutility of 200 for a type L worker and a disutility of 100
for a type H worker.

2) In a labor market there are two types of workers, the high-ability ones (type H) and the low-ability ones
(type L). All potential employers value a high-ability worker at $6,000 per month and a low-ability worker at
$2,000 per month. The supply of high-ability workers is 𝑄𝐻𝑆 (𝑊) = 0.1 × (𝑊 − 1,000) and the supply of low-
ability workers is 𝑄𝐿𝑆 (𝑊) = 0.3 × (𝑊 − 1,000), where 𝑊 is the monthly wage.

a) Assume that workers' abilities are observable to employers. Represent in the following diagram the supply
and demand curves for high ability and low ability workers.

b) Keep assuming that workers' abilities are observable to employers. How many workers of each type will
employers hire? Represent the equilibrium in the diagram above.

c) Assume from now on that workers’ abilities are not observable to employers. What is the fraction of high
ability workers, among those who are willing to work at a given wage? How much is an employer willing to
pay for a worker?

d) How many workers of each type will employers hire? Why does asymmetric information determine a
deadweight loss?

3) In a labor market there are two types of workers, the high-ability ones (type H) and the low-ability ones
(type L). All potential employers value a high-ability worker at $6,000 per month and a low-ability worker at
$2,000 per month. The supply of high-ability workers is 𝑄𝐻𝑆 (𝑊) = 0.1 × (𝑊 − 1,000) and the supply of low-
ability workers is 𝑄𝐿𝑆 (𝑊) = 0.3 × (𝑊 − 1,000), where 𝑊 is the monthly wage. The following diagram
represents the supply and demand curves for high ability and low ability workers.
Microeconomics Patrice De Micco

a) Assume that workers' abilities are observable to employers. How many workers of each type do
employers hire? What are the equilibrium wages?

b) Assume from now on that workers’ abilities are not observable to employers. What is the fraction of high
ability workers, among those who are willing to work at a given wage? How much is an employer willing to
pay for a worker?

c) How many workers of each type will employers hire? Why does asymmetric information determine a
deadweight loss?

4) In a labor market, there are two types of workers, the high-ability ones (type H) and the low-ability ones
(type L). All potential employers value a high-ability worker at $8,000 per month and a low-ability worker at
$2,000 per month. The supply of high-ability workers is 𝑄𝐻𝑆 (𝑊) = 0.2 × (𝑊 − 1,000) and the supply of low-
ability workers is 𝑄𝐿𝑆 (𝑊) = 0.4 × (𝑊 − 1,000), where 𝑊 is the monthly wage.

a) Assume that workers' abilities are observable to employers. How many workers of each type will
employers hire? Represent the equilibrium in the diagram above.

b) Assume from now on that workers’ abilities are not observable to employers. What is the fraction of high-
ability workers, among those who are willing to work at a given wage? How much is an employer willing to
pay for a worker?

c) How many workers of each type will employers hire? Why does asymmetric information determine a
deadweight loss?
Microeconomics Patrice De Micco

Information asymmetry

Exercises

1) A firm is considering hiring a worker whose ability is a hidden characteristic. The firm only knows that the
worker has high ability (type H) with probability p and low ability (type L) with probability 1 – p. By hiring a
high-ability worker the firm obtains a revenue of 2000 euros, while hiring a low-ability worker the revenue is
only 1000. If the firm hires the worker and pays him a wage W, the worker’s payoff is W. Otherwise, the
worker’s payoff is 1200, his reservation wage. The bargaining power is entirely in the hands of the firm, that
is, it is the firm who proposes a contract to the worker.

a) If the worker’s ability were observable, which contract would the firm offer?
In this case the firm would offer 1200 to a type H worker and 1000 to a type L worker, and only the type H
worker would accept.

b) Assume now that the worker’s ability is not observable. Which contract will the firm offer? Is the resulting
allocation Pareto efficient?
The firm’s expected revenue is 2000𝑝 + 1000(1 − 𝑝) = 1000(1 + 𝑝). If 𝑝 ≥ 0.2 then this is greater than
the worker’s reservation wage of 1200, while if 𝑝 < 0.2 it is smaller. Thus the firm will offer 1200 if 𝑝 ≥ 0.2,
while if 𝑝 < 0.2 the firm will not be willing to hire the worker. In both cases the allocation is not socially
efficient, as there will be inefficiently high level of hiring in the first case, and inefficiently low level of hiring
in the second.

c) How would your answer to point b) change, if the firm could offer a wage depending on the task performed
by the worker? Assume here that p = 1/2 and that there are two tasks, an easy task not involving any disutility
for the worker and a more difficult task involving a disutility of 200 for a type L worker and a disutility of 100
for a type H worker.
Since 1/2 > 0.2, the maximum profit that the firm can achieve by offering a wage that does not depend on
the task equals 1000(1 + 𝑝) – 1200 = 300. Alternatively, the firm can offer a contract that only a type H
worker finds acceptable: a wage equal 1200 + 100 = 1300 for the difficult task, which a type H worker finds
just acceptable but a type L worker finds unacceptable. The corresponding profit for the firm would be
𝑝(2000 − 1300) = (1/2)700 = 350. Since 350 > 300, the firm prefers offering the second contract.

2) In a labor market there are two types of workers, the high-ability ones (type H) and the low-ability ones
(type L). All potential employers value a high-ability worker at $6,000 per month and a low-ability worker at
$2,000 per month. The supply of high-ability workers is 𝑄𝐻𝑆 (𝑊) = 0.1 × (𝑊 − 1,000) and the supply of low-
ability workers is 𝑄𝐿𝑆 (𝑊) = 0.3 × (𝑊 − 1,000), where 𝑊 is the monthly wage.

a) Assume that workers' abilities are observable to employers. Represent in the following diagram the supply
and demand curves for high ability and low ability workers.
Microeconomics Patrice De Micco

𝑄𝐻𝑆
𝑄𝐿𝑆

6
Wage (thousands of dollars)

300 500
Workers

b) Keep assuming that workers' abilities are observable to employers. How many workers of each type will
employers hire? Represent the equilibrium in the diagram above.
When ability is observable, equilibrium wage for a high ability worker is 6,000. From this we compute that
𝑄𝐻 = 0,1 × (6.000 − 1.000) = 500 high-ability workers will be hired. The equilibrium wage for a low ability
worker is 2,000, from which we compute that 𝑄𝐿 = 0,3 × (2.000 − 1.000) = 300 low-ability workers will be
hired.

c) Assume from now on that workers’ abilities are not observable to employers. What is the fraction of high
ability workers, among those who are willing to work at a given wage? How much is an employer willing to
pay for a worker?
As long as the wage is at least 1,000, the fraction of type H workers is always 1/4, given that 𝑄𝐻𝑆 /(𝑄𝐿𝑆 +
𝑄𝐻𝑆 ) =1/4 for every value of W. Thus, an employer is willing to pay 1/4*6.000+3/4*2.000=3.000 for a worker.

d) How many workers of each type will employers hire? Why does asymmetric information determine a
deadweight loss?
At wage W=3.000 there are 𝑄𝐻𝑆 = 0,1 × (3.000 − 1.000) = 200 workers of type H and 𝑄𝐿𝑆 = 0,3 × (3.000 −
1.000) = 600 workers of type L who are willing to work. Compared to the case where ability is observable,
too many low-ability workers and too few high-ability workers are hired. In particular, each of the 600-
300=300 additional low-ability workers have a reservation wage higher than their value for the employer
(total surplus would increase if they were not hired). Moreover, each of the 500-200=300 high-ability workers
who are now unemployed have a reservation wage lower than their value for an employer (total surplus would
increase if they were hired).

3) In a labor market there are two types of workers, the high-ability ones (type H) and the low-ability ones
(type L). All potential employers value a high-ability worker at $6,000 per month and a low-ability worker at
$2,000 per month. The supply of high-ability workers is 𝑄𝐻𝑆 (𝑊) = 0.1 × (𝑊 − 1,000) and the supply of low-
ability workers is 𝑄𝐿𝑆 (𝑊) = 0.3 × (𝑊 − 1,000), where 𝑊 is the monthly wage. The following diagram
represents the supply and demand curves for high ability and low ability workers.
Microeconomics Patrice De Micco

a) Assume that workers' abilities are observable to employers. How many workers of each type do
employers hire? What are the equilibrium wages?
When ability is observable, equilibrium wage for a high ability worker is 12,000. From this, we compute that
𝑄𝐻 = 0,05 × (12.000 − 2.000) = 500 high-ability workers will be hired. The equilibrium wage for a low
ability worker is instead 6,000, from which we compute that 𝑄𝐿 = 0,1 × (6.000 − 2.000) = 400 low-ability
workers will be hired.

b) Assume from now on that workers’ abilities are not observable to employers. What is the fraction of high
ability workers, among those who are willing to work at a given wage? How much is an employer willing to
pay for a worker?
As long as the wage is at least 2,000, the fraction of type H workers is always 1/3, given that 𝑄𝐻𝑆 /(𝑄𝐿𝑆 +
𝑄𝐻𝑆 ) =1/3 for every value of W. Thus, an employer is willing to pay 1/3*12.000+2/3*6.000=8.000 for a worker.

c) How many workers of each type will employers hire? Why does asymmetric information determine a
deadweight loss?
At wage W=8.000 there are 𝑄𝐻𝑆 = 0,05 × (8.000 − 2.000) = 300 workers of type H and 𝑄𝐿𝑆 = 0,1 ×
(8.000 − 2.000) = 600 workers of type L who are willing to work. Compared to the case where ability is
observable, too many low-ability workers and too few high-ability workers are hired. In particular, each of the
600-400=200 additional low-ability workers have a reservation wage higher than their value for the employer
(total surplus would increase if they were not hired). Moreover, each of the 500-300=200 high-ability workers
who are now unemployed have a reservation wage lower than their value for an employer (total surplus would
increase if they were hired).

4) In a labor market, there are two types of workers, the high-ability ones (type H) and the low-ability ones
(type L). All potential employers value a high-ability worker at $8,000 per month and a low-ability worker at
$2,000 per month. The supply of high-ability workers is 𝑄𝐻𝑆 (𝑊) = 0.2 × (𝑊 − 1,000) and the supply of low-
ability workers is 𝑄𝐿𝑆 (𝑊) = 0.4 × (𝑊 − 1,000), where 𝑊 is the monthly wage.

a) Assume that workers' abilities are observable to employers. How many workers of each type will
employers hire? Represent the equilibrium in the diagram above.
When ability is observable, equilibrium wage for a high- ability worker is 8,000. From this, we compute that
𝑄𝐻 = 0.2 × (8,000 − 1,000) = 1,400 high-ability workers will be hired. The equilibrium wage for a low-
ability worker is 2,000, from which we compute that 𝑄𝐿 = 0,4 × (2,000 − 1,000) = 400 low-ability workers
will be hired.