Applied Microeconomics

1. Applied Microeconomics Asymmetric Information

2. Outline • Adverse selection • Signaling • Screening

3. Readings • Kreps: Chapter 18 • Perloff: Chapter 19 • Zandt: 12C

4. Introduction • What happens when some market participants know more than others? • Examples: • Sellers who know more about the quality of their product than prospective buyers • Workers who know more about their skills than prospective employees • Insiders who know more about a firm’s value than outside shareholders

5. Types of Information Asymmetries • Unobservable characteristics: adverse selection • Unobservable actions: moral hazard

6. Adverse Selection • In 1994, the average car depreciated 37% in its first year and 13% more under the second year • 35% of all cars were sold through car dealerships, typically offering warranties • The average price of a used car in 1994 was about $11,500, but the average private-sale price for a used car was about $2,000 less

7. Adverse Selection • “Adverse selection occurs when an informed individual’s trading decision depends on her unobservable characteristics in a manner that adversely affects the uninformed agents in the market.”

8. Adverse Selection

9. Example: Market for “Lemons” • Suppose two types of cars – good quality in share g and bad quality “lemons” in share 1-g • Finite number of sellers with reservation prices 1800 Euros for good cars and 800 Euros for bad cars • Numerous risk-neutral buyers with reservation prices 2000 Euros for good cars and 1000 Euros for lemons

10. Example: Market for “Lemons” • If quality observable to buyers, then both types of cars would be traded at prices 2000 and 1000 respectively • If quality unobservable to buyers, and both cars are offered, then buyers are prepared to pay 2000g+(1-g)1000=1000+1000g • Sellers of good cars are willing to sell when 1000+1000g≥1800, or in other words if g≥80%

11. Example: Market for “Lemons” • What if the share of good cars is less than 80%? • Then only bad cars are offered, and, the buyers anticipating this, offer 1000 • Good cars are thus driven out of the market!

12. 2000 1800 1000 800 0.80 g Example: Market for “Lemons” Price

13. Remedies • Screening • Signaling

14. Screening • Remember how firms practicing second-degree price discrimination could choose the quality and tariffs of goods such that different types self-select different goods/bundles? • In the same manner a firm with no information can screen possible counterparties • “Screening refers to activities undertaken by the party without private information in order to separate different types of the informed party along some dimension”

15. Examples of Screening

16. Signaling • In markets with adverse selection, an informed party of high quality may overcome the adverse selection problem by signaling his type • However, the cost of the signal must be such that: • It is not in the interest of an informed party of low quality to imitate and the send the same signal • It is not too expensive for the high type to signal

17. Examples • High-ability workers can signal their ability to firms by acquiring a certain level of education • Entrepreneurs with profitable projects can signal the profitability of the project to VC:s by offering holding on to an equity stake in the venture • Car dealers can signal the quality of a used car by offering a warranty

18. Spence’s Model of Labor Market Signaling • Consider a competitive labor market with workers of marginal productivity L in share q, and workers of marginal productivity H>L in share 1-q • Allworkers are assumed to have a reservation wage of 0 • Firms want to hire workers to perform a task, but ability is not observable to them

19. Spence’s Model of Labor Market Signaling • With symmetric information low productivity workers would be paid a wage of wL=L and high productivity workers a wage of wH=H • With asymmetric information and no way for employers to separate types there would be an equilibrium where all workers received a wage of w=qL+(1-q)H

20. Separating Equilibrium • Suppose now that high productivity workers can get a degree attending school at a cost (psychic and economic) c and that low productivity workers cannot graduate from school • Assume for simplicity that the productivity of the worker is not affected by the education

21. Pooling Equilbria • If H-c>qL+(1-q)H, or equivalently q(H-L)>c, only a separating equilibrium, where only high-productivity workers go to school and firms rightly believe that only graduates are of high productivity, is possible • If on the other hand H-c<L, or equivalently H-L<c, then only a poolingequilibrium with a uniform wage for everyone is possible • If q(H-L)≤c≤H-L, then both types of equilibria are possible

22. Equilibria c Pooling c=q(H-L) c=H-L Separating Both 1 q

23. Problems • If education does not raise productivity, then signaling is often socially inefficient • In our example, output and total wages are the same with and without signaling, but education is costly • Low productivity workers are definitely worse off • If w>H-c>L, then high-ability workers are also worse off • Reason is that private returns to education exceeds net social returns • Education can be socially efficient when it raises total output (lemons market) or productivity

24. Problems • Embarrassment of riches • Hard to make predictions: • Not only both separating and pooling equilibria • Also separating equilibria with different costs of education for high-productivity workers • Some equilibria Pareto dominate others

25. Problems • Self-confirming equilibria are possible: • Suppose employers believe that in addition to education some observable and completely independent characteristic such as sex or skin color is a signal of productivity • Even if the share of low- and high-productivity workers is the same among men and women, we could have a separating equilibrium among male workers and a pooling equilibrium among female workers

26. Conclusion • Adverse selection occurs when asymmetric information about characteristics affect some party adversely • Screening is when the uninformed party designs contracts to elicit information about the characteristics of the informed party • Signaling is when the informed party takes a costly action in order to convey information about his type to the uninformed party