L24

1. L24 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 (Spence, labor markets) • 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