L25
Asymmetric Information
Structure of the course
1) Consumers choice
2) Equilibrium, Producers
(Pareto efficiency)
3) Market Failures
- fixed cost: monopoly and oligopoly
- externalities and public goods
- 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
  1/ 3
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
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 (in Labor Market)


Two types of managers
- high-ability manager has productivity a h  1 (a plum)
- low-ability manager has productivity a l  0 (a lemon)
Fraction of high-productivity managers   1/ 2
w  E (a | I )

Competitive markets

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