L25
Asymmetric Information
Road map
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 the patient.
2. Insurance: 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”
Second hand car market.
 Types of cars: “lemons” and “plums”.

Lemon
Plum
Seller
1000
2000
Buyer
1200
2400

Benchmark: Perfect information

Gains-to-Trade (50% - 50%)
Asymmetric information
Lemon
Plum
Seller
1000
2000
Buyer
1200
2400

Asymmetric information (50% - 50%)

Gains-to-trade and BS, SS
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  )
Gains-to-trade BS and SS
Adverse Selection
Separating equilibrium   1/ 3
 “too many” lemons “crowd out” the plums from the
market.
 gains-to-trade are reduced since no plums are traded
 Bad for plum owners
  1/ 3
Pooling equilibrium
 Lemon owners “hide behind” the plums
 Somewhat bad for plum owners
 Pareto efficiency
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
 Managers can chose the level of education
Cost of education (MBA)
 For high-ability worker education costless
l
l
l
 For low-ability worker c (e )  0.2e
el , e h
c (e )  0
h
h
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?
a  1,
h
 Can
(Non) Credible signal
a  0,
l
c (e )  0,
h
h
we separate with e=2?
c (e )  0.2e
l
l
l
a  1,
(Non) Credible signal
h
 Credibility
a  0,
l
condition
c (e )  0,
h
h
c (e )  0.2e
l
l
l
a  1,
h
 Can
A credible signal
a  0,
l
c (e )  0.1e ,
h
h
h
we separate now?
 Signal
more costly to low type
 Deadweight loss (burning money)
 Common in real world: adds
c (e )  0.2e
l
l
l
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 assume proper incentives
