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L25

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.

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L25

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  1. L25 Asymmetric Information

  2. Road map 1) Consumers choice 2) Equilibrium, Producers (Pareto efficiency) 3) Market Failures - fixed cost: monopoly and oligopoly - externalities and public goods - asymmetric information

  3. Asymmetric Information • Assumption: full information about the traded commodities • What about following markets? • Medical services: a doctor knows more than does the patient. • Insurance: buyer knows more about his riskiness than does the seller. • Used cars: a car’s owner knows more about it than does a potential buyer • Problem: asymmetric information

  4. Today • Q: how does asymmetric information affect the functioning of a market? • Important phenomena • adverse selection (hidden information) • signaling • moral hazard (hidden action)

  5. Market for “lemons” • Second hand car market. • Types of cars: “lemons” and “plums”. • Benchmark: Perfect information • Gains-to-Trade (50% - 50%)

  6. Asymmetric information • Asymmetric information (50% - 50%) • Gains-to-trade and BS, SS

  7. Separating equilibrium • Asymmetric information ( , )

  8. Pooling equilibrium • Asymmetric information ( , ) • Gains-to-trade BS and SS

  9. Adverse Selection Separating equilibrium • “too many” lemons “crowd out” the plums from the market. • gains-to-trade are reduced since no plums are traded • Bad for plum owners Pooling equilibrium • Lemon owners “hide behind” the plums • Somewhat bad for plum owners • Pareto efficiency Probability of “bad type” is high: compulsory insurance

  10. 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.

  11. Signaling (in Labor Market) • Two types of managers - high-ability manager has productivity (a plum) - low-ability manager has productivity (a lemon) • Fraction of high-productivity managers • Competitive markets • Benchmark: No signal (pooling)

  12. Equilibrium with signaling Signal: MBA education • Managers can chose the level 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 • It is a deadweight loss • Q: Is there a separating equilibrium with signaling?

  13. (Non) Credible signal • Can we separate with e=2?

  14. (Non) Credible signal • Credibility condition

  15. A credible signal • Can we separate now? • Signal more costly to low type • Deadweight loss (burning money) • Common in real world: adds

  16. 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).

  17. Moral hazard • Perfect information: full insurance • Asymmetric information: • partial insurance • contract that depends on output To assume proper incentives

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