Asymmetric information 1

Lecture 6 Tom Holden Intermediate Microeconomics Semester 2

http://micro2.tholden.org/

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Introduction
Asymmetric information (AI) occurs in interactions between two or more parties, when one knows more than the other.
E.g. buyers and sellers, or principals and agents. One party knows more than the other.

Two main types of AI:

Hidden characteristics:
E.g. What type of good are you buying? What type of person are you? Leads to adverse selection problems.

Hidden actions:
If I cannot commit not to cheat in some way, you will assume I am cheating. Leads to moral hazard problems.
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Examples of AI
The seller knows the quality of a good, the buyer does not. The employee knows their productivity the worker does not. The insured knows how likely they are to claim, the insurer does not. The potential buyer knows their willingness to pay, the seller does not. Etc.

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Reading
Varian, Chapter 37 MKR, Chapter 17 (second half) Additional reading for adverse selection in insurance markets (if desired):
Frank Cowell, Microeconomics: Principles and Analysis
Chapter 11, especially 11.2.6

Hugh Gravelle & Ray Rees, Microeconomics

Chapter 19, especially sub-section F

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Aims for this topic

Today:
To understand adverse selection.
In product markets. In insurance markets.

To see how signalling may solve adverse selection.

Example of education.

In a fortnight:
Moral Hazard.
Principal-agent models.

Note: This topic will not be on next weeks test.

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Adverse selection: Lemons (1/5)

The classic lemons example, due to Akerlof. Two types of used car:
plums (good) lemons (bad)

Buyers cant tell the difference between plums and lemons, but sellers know what theyre selling.

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Adverse selection: Lemons (2/5)

Owner of a lemon willing to sell for $1000. Buyer willing to pay $1200. Owner of a plum willing to sell for $2000. Buyer willing to pay $2400.

If a buyer cant tell the difference between a plum and a lemon, and they think its equally likely that it could be either, then their expected value of the car is $1800.
Its not worth it for a plum owner to sell. Putting car up for sale signals that its a lemon. If there are no plums then the buyer wont be willing to offer $1800.

Only market for lemons will operate and price paid will be between $1000 and $1200.

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Adverse selection: Lemons (3/5)

Suppose buyers value plums at and lemons at , with > . Suppose sellers value plums at and lemons at , with > and > & > . Suppose a fraction of cars that sellers would like to sell are plums.

And suppose a fraction of all cars actually being sold are plums.
So for a buyer, the expected value of a car is: + 1 .

So the price of a car must be less than + 1 .

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Adverse selection: Lemons (4/5)

Three cases:
, so + 1 for any :
Then = and a price between and + 1 is chosen, and both lemons and plums are sold. Price under perfect competition? Consumer surplus?

< and satisfies + 1 :

Again a price between and + 1 is chosen, and both lemons and plums are sold. Lowest possible ? Other equilibria?

< and satisfies + 1 < :

Then if both lemons and plums were sold, sellers of plums would make a loss. Thus only lemons are sold, = 0 and the price is between and .

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Adverse selection: Lemons (5/5)

Extra condition for both lemons and plums to be sold:
Suppose currently both plums and lemons were sold at a price . A seller of a lemon might be tempted to offer a price of < . A consumer would accept this if .
The lower is, the more tempting this looks.

The seller would never go below , thus to rule out any lemon sellers undercutting the market, we must have: < , i.e. < . Otherwise only lemons will be sold.

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Quality choice (1/2)

Suppose plums can be created (by sellers) for and lemons can be created for , where . Again assume > and > . If = , then firms are indifferent between producing the two cars, as long as there is a market for each. Suppose plums are produced.
There is an equilibrium for any satisfying: 1

Are there any other equilibria?

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Quality choice (2/2)

Now suppose > . Would sellers ever produce a plum?

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Solutions to adverse selection

Government quality certification? Reputation
Can only operate where there are positive economic profits to be earned.

Compulsory sale/purchase.
E.g. mandatory health insurance purchase.

Signalling.
E.g. warranties.

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Adverse selection in insurance markets (1/5)

High risk () and low risk () agents. Each can be in two states, for good and for bad.
and are the probabilities of the bad state for high risk and low risk types respectively (so > ).
Income in the good state is for both types, and its in the bad state for both types.

Insurance sellers cannot tell they types apart and offer a premium of to both.

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Adverse selection in insurance markets (2/5)

Assuming both types have the same preferences, from our uncertainty lecture we have:

= high risk types.

+

1 1

where is the amount of insurance purchased by

And: = by low risk types. Thus:

+ 1

1 1

where is the amount of insurance purchased

+ 1

= 1.

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Adverse selection in insurance markets (3/5)

> , so

>

, 1

so:

<

This in turn implies that > (i.e. high risk types insure more), as the fact that marginal utility is decreasing in consumption means:
+

+ 1

<0

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Adverse selection in insurance markets (4/5)

We started this analysis by saying that the insurance company could not tell the two types apart.
But we have just proven that high risk types demand more insurance. Adverse selection!

So in fact the insurance company can tell the types apart from their insurance demands, so will want to offer a higher premium to the high risk types.
E.g. the insurance company might choose to make their premium an increasing function of the amount insured. Has to ensure that the high risk types do not benefit from pretending to be low risk and taking a lower amount of cheaper insurance.

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Adverse selection in insurance markets (5/5)

Suppose making the premium a function of the amount demanded is not feasible.
Let the fraction of high risk in the population be . Expected insurer profit is: + 1 The actuarially fair premium is equal to the probability of the bad state in the whole population, i.e. + 1 . If insurers set to this level then profits are:

+ 1 + 1 + 1 = 1 + 1 = 1 < 0
So in the face of adverse selection, insurers will price above the actuarially fair level, causing inefficiency. In fact the more they charge, the bigger the gap between and , so the more they want to charge. May lead to = 0.

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Compulsory purchase
Suppose all agents were forced to buy units of insurance.
E.g. in the UK we are all forced to buy the same amount of health insurance through taxes. In the US many jobs come with health insurance bundled in.

Then the expression for profits with the actuarially fair premium from the last slides would be: 1 = 0
So with free entry of insurers, premiums would be set to the actuarially fair level. This may leave both high and low risk types better off, since they will both now face lower premiums (though the low risk type will not be as well off as if types were observable).
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Signalling and screening

Signalling occurs when the informed side of the market chooses to reveal something about their hidden characteristics.
In our lemons model, sellers of plums might like to offer warranties. This would be too expensive for lemon sellers.

In order to contain information, signals must be incentive compatible: agents must have no incentive to send the signal normally sent by a different type. The uninformed side of the market uses the signal to screen for the type of characteristics they want. Another way of thinking of this is that the informed side of the market self-selects.
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Signalling and price discrimination

Two types of train travellers from Portsmouth to London.
Business travellers are willing to pay 60, pleasure travellers are willing to pay 20. Business travellers prefer to be in London by 9.30. Pleasure travellers are willing to travel later therefore they will buy an off peak ticket if its cheaper.

If the price is over 20, pleasure travellers would not travel.

This is a loss of welfare on both sides as marginal cost of an extra passenger (especially later in the day) is very low.

If price is set at 20 or below firm wouldnt be extracting maximum profit from business travellers.
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Price discrimination requires:

That the firm has some monopoly power. That the firm can identify different types of consumer. That consumers cannot engage in arbitrage. In this example the consumers are willingly revealing their types to the firm. They signal their types by the type of ticket they buy (provided this is incentive compatible).
If business prices get too high the business traveller will start to behave like a pleasure traveller.

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Signalling and education

A firm wishes to hire workers. If productivity is observable then each worker is paid a wage equal to their marginal product. Imagine productivity is not observable and there are two types of workers, high ability and low ability. In this case the firm can only pay workers according to their expected productivity. High productivity workers would clearly prefer to differentiate themselves if possible. If education is cheaper for them, then by obtaining education they can mark themselves as high ability.
Plausible that high ability types find the work easier. High ability types may have higher opportunity costs though.

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Diagrammatic analysis of education as a signal

earnings Taking education has a disutility. Therefore individuals are happier with no university degree and more money

No university degree

University degree

Years of education

Indifference curves are different for workers of different abilities

low ability
high ability
Low ability person finds education harder, so theyre willing to trade more money for less ed. IC is therefore steeper.

earnings

No university degree

University degree

Years of education

Education signalling (1/4)

Let be the productivity of the able type and be the productivity of the less able one. ( > ). Suppose there are able types in total, so in the absence of signalling the wage is given by + 1 . Suppose the able type can acquire education at a cost of and the less able type can acquire it at a cost , with < .

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Education signalling (2/4)

Suppose no one acquires any education. Does anyone have any incentive to deviate to acquiring some?
Imagine for the moment that a firm promised a wage of to anyone acquiring at least units of education.
Acquiring this education would make sense for a low type if + 1 , i.e. if 1 . Thus for the firms offer to be sensible, it must be the case that 1 > 1 .

Anyone acquiring more than 1 units of education in this situation would be unambiguously a high type, so in a competitive market they would be paid . But as < high type people would strictly prefer this.

Thus, no one acquiring any education is not an equilibrium. There is no pooling equilibria.

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Education signalling (3/4)

Suppose instead that high types acquire units of education, and low types acquire none. Then high types will be paid and low types will be paid . For a high type not to want to pretend to be a low type it must be the case that: > , i.e. < .

For a low type not to want to pretend to be a high type it must be the case that: > . i.e. > .

Since < these inequalities may be satisfied simultaneously, so there is a separating equilibria in which different types acquire different education levels.

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Education signalling (4/4)

The separating equilibria is inefficient since education is pure waste in this model.
The same output would be produced had no one acquired any education. Income is trivially lower for low types.

For high types, income is < = 1 +

,

so if 1

< , income is lower for high types too.

If instead we had assumed that > (high types find education more costly, perhaps due to better outside options), then we would have found the pooling equilibria existed, but the separating did not.
So e.g. a high graduate tax may actually reduce inefficiency.

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Education and adverse selection (1/3)

In the last model education signalling was unambiguously bad when high types find education easier than low types.
But in the presence of adverse selection it may be welfare improving.

Suppose that all agents value not being employed at times their productivity (where 0 < 1).
This may be the value of watching TV, or the value of the goods you could produce yourself without being employed.

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Education and adverse selection (2/3)

In the absence of signalling, with everyone working at firms, the wage would be + 1 as before. But suppose > + 1
.

Then high types prefer staying at home to earning a wage of + 1 in a firm.

Thus without signalling, only low types work in firms, for a wage of .

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Education and adverse selection (3/3)

The deadweight loss (DWL) due to adverse selection is 1 . When + 1
,

the DWL is roughly 1 .

The DWL due to signalling is .

With

this DWL is roughly

So when < 1 , signalling may be welfare improving under adverse selection.

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The meaning of inefficiency in an AI context

Its not a lack of information that causes problems in the circumstances we have identified; its the presence of asymmetric information. If neither party knew which cars were lemons, then the market could operate. This is the appropriate comparison, not one with full information. Signalling improves efficiency because it makes the best use of the information available.

Outcomes which do not do this are inefficient.

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Evaluating the signalling hypothesis

The human capital model states that education actually improves productivity. Both models predict that:
Those with higher education will earn more. Those with more education are more productive. Education will be obtained early in life.

Is the expensiveness of the education system an argument against the signalling view? Could the market provide a cheaper signal? Robin Hanson: People in business signal to each other all the time. In fact, most of the on-the-job business learning that employees do after college, such as how to dress well, how to give presentations, how to write memos, how to talk with clients, etc. might be skills that are mainly useful to signal innate features to bosses, co-workers, clients, etc. So employers might pay more for students with prestigious degrees because such degrees show an ability to learn how to later send good business signals. http://is.gd/zxjdw2 Distinguishing between the two theories is crucial for policy though.
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Education as Learning to signal makes it even harder to distinguish the signalling and the human capital views.

Tests of signalling / human capital

Signalling model assumes employers do not have full information, education likely to be less important when they have the opportunity to learn about productivity.
Importance of education may go down over time.

Signalling model likely to be associated with sheepskin effects, which put a value on accreditation.
Evidence in Varian suggests those years of education which lead to a certificate have a bigger impact on your wage.

Manoli (2008) http://is.gd/ohVCvb suggests signalling accounts for up to 40% of the educational wage premium.
Learning to signal better may account for the rest
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In the next topic

Well discuss moral hazard, with a focus on insurance markets. Well also use this framework to compare healthcare systems between the UK and the US. And well introduce the principal-agent problem, another way of thinking about and solving moral hazard problems.

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