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Asymmetric Information. Perloff Chapter 19. Asymmetric Information. When two parties to a transaction have different information. Adverse Selection When an informed person has an advantage through an unobserved characteristic .
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Asymmetric Information Perloff Chapter 19
Asymmetric Information • When two parties to a transaction have different information. • Adverse Selection • When an informed person has an advantage through an unobserved characteristic. • Eg a disproportionately large number of unhealthy people buy life insurance. • Moral Hazard • When an informed person has an advantage through an unobserved action. • An insured car driver drives faster.
Equalising information • Screening • Obtaining information about hidden characteristics. • Insurance. • Costly. • Signalling • Use of public information to indicate the nature of private information. • Restaurant.
Market for lemons and good cars (a) Market for Lemons (b) Market for Good Cars L S Price of a lemon, $ E Price of a good car, $ G 2,000 D 1,750 2 S f F * 1,500 * 1,500 D D 1,250 1 S e L 1,000 D 750 0 1 ,000 0 1 ,000 Lemons per year Good cars per year
Laws Product liability laws, Consumer screening The use of a mechanic, Reputation, Third party comparisons, ‘Which’ reports, Standards and certification, Kite marks, Signalling by firms Brand names to differentiate product. Preventing the occurrence of lemon markets
Price Discrimination Through Asymmetric Information • Charge a different price according to willingness to pay. • Some consumer’s may falsely believe a product is of a higher quality. • Own label product.
Tourist Trap Model • Pure competitive market: • All firms charge the same price. • A higher price results in zero demand. • Imperfect information in a competitive market. • Know the prices charged by shops but not specific price charged by a specific shop. • Competitive price is p*. • Firm can charge p*+e. • e is less than cost of finding another shop.
Monopoly price in a ‘tourist trap’ • Suppose all firms charge p*+e • Same reasoning implies all firms can raise price to p*+2e • This argument can continue to be applied until all firms charge the monopoly price. • At this price further price increases result in a loss of profit. • In a market where finding prices is costly the equilibrium price is the monopoly price. • If firms are allowed to advertise prices so that search costs disappear the competitive price results.
Employee safety with asymmetric information • Employees in safer industries pay lower wages than in unsafe. • Safety statistics are reported at industry levels, not the firm level.
Education as a signal • Low ability people will not graduate. • Have to accept lower unskilled wage. • High ability people will go to college if difference between skilled and unskilled wage exceeds cost of education • Two equilibrea are possible • Pooling • When costs of education exceed the wage differential and everyone is paid the same. • Seperating • When it pays to go to college.
Unique or multiple equilibrea Pooling equilibrium c, Cost per diploma, $ c = w – w 20,000 h l Pooling or separating equilibrium x y 15,000 z 5,000 c = – — — — — 1 q w – w h l Separating equilibrium 0 1 1 1 – – 4 2 , Share of high-ability workers q
