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Understanding Asymmetric Information in Market Efficiency

Learn how asymmetric information impacts markets through concepts like adverse selection, signaling, and moral hazard. Explore scenarios from medical services to used cars and gain insights into separating and pooling equilibriums. Discover how credible signals, such as education and warranties, can mitigate information imbalances.

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Understanding Asymmetric Information in Market Efficiency

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  1. L25 Asymmetric Information

  2. Market Efficiency 1) Competitive markets are efficient 2) Market failures a) market power b) externalities c) public goods d) asymmetric information

  3. Asymmetric Information • Assumption: full information about the traded commodities • What about following markets? • Medical services: a doctor knows more than does a patient. • Insurance: a 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” • Market for used cars (Akerlof 1970) • Types of cars: “lemons” and “plums”. • Proportion: 50% - 50% • TPS (Total Potential Surplus)

  6. Benchmark: perfect information • Prices (halfway): • Buyer’s and seller’s surplus • TPS and BS+SS?

  7. Asymmetric information • Asymmetric information (50% - 50%) • TPS and BS, SS • Separating Equilibrium

  8. Separating equilibrium • Asymmetric information ( , )

  9. Pooling equilibrium • Asymmetric information ( , ) • Efficient outcome

  10. Adverse Selection Separating equilibrium • Lemons “crowd out” plums from the market. • Surplus is reduced since no plums are traded • Very bad for plum owners 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

  11. 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.

  12. 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)

  13. 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?

  14. (Non) Credible signal • Is MBA a credible signal with e=2? • Suppose

  15. Credible signal • Credibility condition

  16. A credible signal • Can we separate now? • Same credibility condition • Deadweight loss (burning money) • Common in real world: adds

  17. 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).

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

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