Asymmetric information

1. Introductory to Microeconomics 1st edition Chapter 17 Asymmetric information Wyn Morgan

2. Introduction • In many transactions, the people involved have different amounts of information.

3. Introduction • As well as many other situations in which one side of deal knows something that the other does not, e.g. buying used car or when a firm hires a new employee!

4. Introduction • As well as many other situations in which one side of deal knows something that the other does not, e.g. buying used car or when a firm hires a new employee! • Where one side know more than the other we have ‘asymmetric information’.

5. Asymmetric information • The existence of asymmetric gives rise to: • Hidden characteristics • Hidden actions

6. Hidden characteristics • Whenever one side of the a transactions knows something about itself that the other side does not know, we have ‘hidden characteristics’.

7. Hidden actions • Whenever one die of the an economic relationship takes actions that the other side cannot observe is a situation of ‘hidden cost’.

8. Signalling and screening • We next examine the effects of hidden characteristics on the operation and performance of markets.

9. Another look at discrimination • Typically consumers know how much they are willing to pay for a good, but the firm selling to them does not!

10. Another look at discrimination • Typically consumers know how much they are willing to pay for a good, but the firm selling to them does not! • The firm would like to know what customers are prepared to pay:

11. Another look at discrimination • Typically consumers know how much they are willing to pay for a good, but the firm selling to them does not! • The firm would like to know what customers are prepared to pay: • Via signals and screening

12. Normative analysis of second degree price discrimination • When possible, second degree price discrimination can raise the sellers profits.

13. Normative analysis of second degree price discrimination • When possible, second degree price discrimination can raise the sellers profits. • The question here is what happens to total surplus when price changes?

14. Normative analysis of second degree price discrimination • When possible, second degree price discrimination can raise the sellers profits. • The question here is what happens to total surplus when price changes?

15. Normative analysis of second degree price discrimination • When possible, second degree price discrimination can raise the sellers profits. • The question here is what happens to total surplus when price changes? • This gives rise to: • Allocate efficiency • Welfare effects

16. Competitive market signalling • Under second degree price discrimination, a firm with market power uses a signal to sort consumers and discriminate among them!

17. Competitive market signalling • Under second degree price discrimination, a firm with market power uses a signal to sort consumers and discriminate among them! • The use of signals also can be an important phenomenon in competitive markets.

18. Competitive market signalling - example • The example considered here is one low ability and high ability workers (Spence 1974)

19. Competitive market signalling - example • The example considered here is one low ability and high ability workers (Spence 1974) • The question that arises here is: • Why consumer education?

20. Competitive market signalling - example • The answer must be that there are some offsetting benefits from consuming education despite the initial costs involved!

21. The income-budget curve

22. Equilibrium education choice for high ability worker

23. What about the low ability worker? • By assumption, the disutility of going to university is higher for these workers.

24. What about the low ability worker? • By assumption, the disutility of going to university is higher for these workers. • Therefore, the low ability person needs greater compensation for getting through an additional year of education than for the high ability person, ceteris paribus.

25. Equilibrium education choice for a low ability worker

26. Normative analysis of education as a signal • The question here how does the use of education as a signal affect the surplus of different types of workers?

27. Normative analysis of education as a signal • The question here how does the use of education as a signal affect the surplus of different types of workers? • Note that high ability worker’s wages rise because of more schooling.

28. Normative analysis of education as a signal • The question here how does the use of education as a signal affect the surplus of different types of workers? • Note that high ability worker’s wages rise because of more schooling. • And that low ability workers are low because of less schooling.

29. Normative analysis of education as a signal

30. Id education really just a signal? • The conclusion here is that education as a signal are very disturbing to many people and important to consider:

31. Id education really just a signal? • The conclusion here is that education as a signal are very disturbing to many people and important to consider: • Wages rise with more schooling

32. Id education really just a signal? • The conclusion here is that education as a signal are very disturbing to many people and important to consider: • Wages rise with more schooling • The model may lead to too a special outcome to lead to any real outcome

33. Adverse selection • In some markets, the very fact that the informed party wants to deal with the uninformed party can serve as signal!

34. More on insurance markets! • The question, here, is how much insurance to buy? • What if the probability of the negative outcome being observes increases but this is not communicated to the insurance company – what happens?

35. More on insurance markets! • The analysis can be done on two fronts: • The full information equilibrium • Partial information available

36. More on insurance markets! • The analysis can be done on two fronts: • The full information equilibrium • Partial information available • The asymmetric information equilibrium

37. Full information equilibrium - illustrated

38. Partial information - illustrated

39. Asymmetric information equilibrium • Here the situation is that the person taking out the insurance does not inform the insurance company of the full facts!

40. Asymmetric information equilibrium - illustrated

41. Asymmetric information equilibrium • When tastes differ such that an individual is prepared to drop out of the market what happens then?

42. Asymmetric information equilibrium - illustrated

43. Asymmetric information equilibrium - illustrated

44. Market responses to adverse selection • We have seen thus far that asymmetric information can be adverse consequences for efficiency.

45. Market responses to adverse selection • We have seen thus far that asymmetric information can be adverse consequences for efficiency. • Examples here would be: • Insurance and testing for AIDS • Group health plans • Targeted insurance rates

46. Other markets in which adverse selection is important • Adverse selection is not just confined to insurance markets. It can be applied to: • Labour markets • The market for human blood (Politis, 2000)

47. Government responses to hidden characteristics • Hidden characteristics may fall short of achieving efficient outcomes if everyone were to be fully informed.

48. Government responses to hidden characteristics • Hidden characteristics may fall short of achieving efficient outcomes if everyone were to be fully informed. • This raises the possibility that government intervention could intervene and improve matters!

49. Government responses to hidden characteristics • Example of this is: • Compulsory public pension programmes

50. Government responses to hidden characteristics • Example of this is: • Compulsory public pension programmes • Informational disseminating policies