L24

Asymmetric Information
 Market Efficiency
1) Competitive markets are efficient

2) Market failures
a) market power
b) externalities
c) public goods
d) asymmetric information
 Asymmetric Information
 Assumption: full information about the
traded commodities

 What about following markets?

1. Medical services: a doctor knows more
than does a patient.
2. Insurance: a buyer knows more about
his riskiness than does the seller.
3. Used cars: a car’s owner knows more
about it than does a potential buyer

 Problem: asymmetric information

 Today
 Q: how does asymmetric information affect the
functioning of a market?

 Important phenomena
 adverse selection (hidden information)
 signaling
 moral hazard (hidden action)
 Market for “lemons”
 Market for used cars (Akerlof 1970)
 Types of cars: “lemons” and “plums”.
 Proportion: 50% - 50%
Lemon Plum
Seller 1000 2000
Buyer 1200 2400

 TPS (Total Potential Surplus)

Benchmark: perfect information

Lemon Plum
Seller 1000 2000
Buyer 1200 2400

 Prices (halfway):

 Buyer’s and seller’s surplus

 TPS and BS+SS?

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

 TPS and BS, SS

 Separating Equilibrium
 Separating equilibrium
Lemon Plum
Seller 1000 2000
Buyer 1200 2400

 Asymmetric information (  , 1   )
 Pooling equilibrium
Lemon Plum
Seller 1000 2000
Buyer 1200 2400

 Asymmetric information (  , 1   )

 Efficient outcome
 Adverse Selection
Separating equilibrium   1/ 3
 Lemons “crowd out” plums from the market.
 Surplus is reduced since no plums are traded
 Very bad for plum owners

Pooling equilibrium   1/ 3
 Lemon owners “hide behind” the plums
 Somewhat bad for plum owners
 Pareto efficiency (full surplus)

Probability of “bad type” is high: compulsory insurance

 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.
 Signaling (Spence, labor markets)
 Two types of managers
- high-ability manager has productivity a plum)
h(a
1
- low-ability manager has productivity a l (alemon)
0
 Fraction of high-productivity managers
  1/ 2
 Competitive markets
w  E (a | I )

 Benchmark: No signal (pooling)

 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?

 (Non) Credible signal
 Is MBA a credible signal with e=2?
 Suppose
 Credible signal
 Credibility condition
 A credible signal
 Can we separate now?

 Same credibility condition

 Deadweight loss (burning money)
 Common in real world: adds
 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).
 Moral hazard
 Perfect information: full insurance
 Asymmetric information:

- partial insurance
- contract that depends on output
To induce proper incentives