Asymmetric information 1

Lecture 6 – Tom Holden Intermediate Microeconomics Semester 2

ECO2051 – Intermediate Microeconomics

• 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.
ECO2051 – Intermediate Microeconomics

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.

ECO2051 – Intermediate Microeconomics

Chapter 37 • MKR. especially 11.2. especially sub-section F ECO2051 – Intermediate Microeconomics .6 • Hugh Gravelle & Ray Rees. “Microeconomics” • Chapter 19.Reading • Varian. Chapter 17 (second half) • Additional reading for adverse selection in insurance markets (if desired): • Frank Cowell. “Microeconomics: Principles and Analysis” • Chapter 11.

• Note: This topic will not be on next week’s test. ECO2051 – Intermediate Microeconomics . • In a fortnight: • Moral Hazard. • Principal-agent models. • Example of education.Aims for this topic • Today: • To understand adverse selection. • To see how signalling may solve adverse selection. • In product markets. • In insurance markets.

Adverse selection: “Lemons” (1/5) • The classic “lemons” example. but sellers know what they’re selling. • Two types of used car: • plums (good) • lemons (bad) • Buyers can’t tell the difference between plums and lemons. due to Akerlof. ECO2051 – Intermediate Microeconomics .

ECO2051 – Intermediate Microeconomics . • If a buyer can’t tell the difference between a plum and a lemon. • Owner of a plum willing to sell for $2000. then their expected value of the car is $1800. Buyer willing to pay $1200. Buyer willing to pay $2400. • Putting car up for sale signals that it’s a lemon. • Only market for lemons will operate and price paid will be between $1000 and $1200. • It’s not worth it for a plum owner to sell. and they think it’s equally likely that it could be either. • If there are no plums then the buyer won’t be willing to offer $1800.Adverse selection: “Lemons” (2/5) • Owner of a lemon willing to sell for $1000.

ECO2051 – Intermediate Microeconomics . • Suppose sellers value plums at 𝑣𝑃 and lemons at 𝑣𝐿 . • And suppose a fraction 𝑞 of all cars actually being sold are plums. with 𝑣𝑃 > 𝑣𝐿 and 𝑟𝑃 > 𝑣𝑃 & 𝑟𝐿 > 𝑣𝐿 .Adverse selection: “Lemons” (3/5) • Suppose buyers value plums at 𝑟𝑃 and lemons at 𝑟𝐿 . the expected value of a car is: 𝑞𝑟𝑃 + 1 − 𝑞 𝑟𝐿 . • Suppose a fraction 𝑞∗ of cars that sellers would like to sell are plums. • So for a buyer. with 𝑟𝑃 > 𝑟𝐿 . • So the price of a car must be less than 𝑞𝑟𝑃 + 1 − 𝑞 𝑟𝐿 .

ECO2051 – Intermediate Microeconomics .Adverse selection: “Lemons” (4/5) • Three cases: • 𝑟𝐿 ≥ 𝑣𝑃 . • Lowest possible 𝑞∗ ? Other equilibria? • 𝑟𝐿 < 𝑣𝑃 and 𝑞 ∗ satisfies 𝑞 ∗ 𝑟𝑃 + 1 − 𝑞 ∗ 𝑟𝐿 < 𝑣𝑃 : • Then if both lemons and plums were sold. and both lemons and plums are sold. • Price under perfect competition? Consumer surplus? • 𝑟𝐿 < 𝑣𝑃 and 𝑞 ∗ satisfies 𝑞 ∗ 𝑟𝑃 + 1 − 𝑞 ∗ 𝑟𝐿 ≥ 𝑣𝑃 : • Again a price between 𝑣𝑃 and 𝑞∗ 𝑟𝑃 + 1 − 𝑞 ∗ 𝑟𝐿 is chosen. so 𝑞𝑟𝑃 + 1 − 𝑞 𝑟𝐿 ≥ 𝑣𝑃 for any 𝑞 : • Then 𝑞 = 𝑞 ∗ and a price between 𝑣𝑃 and 𝑞 ∗ 𝑟𝑃 + 1 − 𝑞 ∗ 𝑟𝐿 is chosen. sellers of plums would make a loss. 𝑞 = 0 and the price is between 𝑣𝐿 and 𝑟𝐿 . • Thus only lemons are sold. and both lemons and plums are sold.

• A consumer would accept this if 𝑟𝐿 − 𝑝 ≥ 𝑟𝑃 − 𝑣𝑃 . • The seller would never go below 𝑣𝐿 .e. • A seller of a lemon might be tempted to offer a price of 𝑝 < 𝑣𝑃 . i. we must have: 𝑟𝐿 − 𝑣𝐿 < 𝑟𝑃 − 𝑣𝑃 . thus to rule out any lemon sellers undercutting the market. • The lower 𝑝 is. • Otherwise only lemons will be sold. ECO2051 – Intermediate Microeconomics .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 𝑣𝑃 . 𝑣𝑃 − 𝑣𝐿 < 𝑟𝑃 − 𝑟𝐿 . the more tempting this looks.

• Again assume 𝑟𝑃 > 𝑐𝑃 and 𝑟𝐿 > 𝑐𝐿 .Quality choice (1/2) • Suppose plums can be created (by sellers) for 𝑐𝑃 and lemons can be created for 𝑐𝐿 . • If 𝑐𝑃 = 𝑐𝐿 . as long as there is a market for each. • Suppose 𝑞∗ plums are produced. where 𝑐𝑃 ≥ 𝑐𝐿 . • There is an equilibrium for any 𝑞 ∗ satisfying: 𝑐 −𝑟 • 𝑟𝑃 −𝑟𝐿 ≤ 𝑞 ∗ ≤ 1 𝑃 𝐿 • Are there any other equilibria? ECO2051 – Intermediate Microeconomics . then firms are indifferent between producing the two cars.

• Would sellers ever produce a plum? ECO2051 – Intermediate Microeconomics .Quality choice (2/2) • Now suppose 𝑐𝑃 > 𝑐𝐿 .

warranties. mandatory health insurance purchase. • E. ECO2051 – Intermediate Microeconomics .g. • E.Solutions to adverse selection • Government quality certification? • Reputation • Can only operate where there are positive economic profits to be earned. • Compulsory sale/purchase.g. • Signalling.

• 𝑝𝐻 and 𝑝𝐿 are the probabilities of the bad state for high risk and low risk types respectively (so 𝑝𝐻 > 𝑝𝐿 ). • Each can be in two states. • Income in the good state is 𝑦𝐺 for both types. • Insurance sellers cannot tell they types apart and offer a premium of 𝜋 to both.Adverse selection in insurance markets (1/5) • High risk (𝐻) and low risk (𝐿) agents. and its 𝑦𝐵 in the bad state for both types. 𝐺 for good and 𝐵 for bad. ECO2051 – Intermediate Microeconomics .

Adverse selection in insurance markets (2/5) • Assuming both types have the same preferences. • Thus: 𝑝𝐻 𝑢′ 𝑦𝐵 −𝜋𝑥𝐻 +𝑥𝐻 1−𝑝𝐻 𝑢′ 𝑦𝐺 −𝜋𝑥𝐻 𝜋 1−𝑝𝐿 1−𝜋 where 𝑥𝐿 is the amount of insurance purchased = 𝑝𝐿 𝑢′ 𝑦𝐵 −𝜋𝑥𝐿 +𝑥𝐿 1−𝑝𝐿 𝑢′ 𝑦𝐺 −𝜋𝑥𝐿 = 1−𝜋. 𝜋 ECO2051 – Intermediate Microeconomics . 𝑢′ 𝑦𝐵 −𝜋𝑥𝐿 +𝑥𝐿 𝑢′ 𝑦𝐺 −𝜋𝑥𝐿 𝜋 1−𝑝𝐻 1−𝜋 where 𝑥𝐻 is the amount of insurance purchased by • And: = 𝑝 𝐿 by low risk types. from our uncertainty lecture we have: • 𝑢′ 𝑦𝐵 −𝜋𝑥𝐻 +𝑥𝐻 𝑢′ 𝑦𝐺 −𝜋𝑥𝐻 = 𝑝 𝐻 high risk types.

Adverse selection in insurance markets (3/5) • 𝑝𝐻 > 𝑝𝐿 . as the fact that marginal utility is decreasing in consumption means: • ⅆ 𝑢′ 𝑦𝐵 −𝜋𝑥+𝑥 ⅆ𝑥 𝑢′ 𝑦𝐺 −𝜋𝑥 = ⅆ 𝑢′ 𝑦𝐵 + 1−𝜋 𝑥 ⅆ𝑥 𝑢′ 𝑦𝐺 −𝜋𝑥 <0 ECO2051 – Intermediate Microeconomics . so • 𝑝𝐻 1−𝑝𝐻 > 𝑝𝐿 . 1−𝑝𝐿 so: 𝑢′ 𝑦𝐵 −𝜋𝑥𝐻 +𝑥𝐻 𝑢′ 𝑦𝐺 −𝜋𝑥𝐻 < 𝑢′ 𝑦𝐵 −𝜋𝑥𝐿 +𝑥𝐿 𝑢′ 𝑦𝐺 −𝜋𝑥𝐿 • This in turn implies that 𝑥𝐻 > 𝑥𝐿 (i. high risk types insure more).e.

• 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. ECO2051 – Intermediate Microeconomics . so will want to offer a higher premium to the high risk types.Adverse selection in insurance markets (4/5) • We started this analysis by saying that the insurance company could not tell the two types apart. • E. • Adverse selection! • So in fact the insurance company can tell the types apart from their insurance demands. the insurance company might choose to make their premium an increasing function of the amount insured. • But we have just proven that high risk types demand more insurance.g.

• Let the fraction of high risk in the population be 𝑞 . • If insurers set 𝜋 to this level then profits are: 𝑞 𝑞𝑝𝐻 + 1 − 𝑞 𝑝𝐿 − 𝑝𝐻 𝑥𝐻 + 1 − 𝑞 𝑞𝑝𝐻 + 1 − 𝑞 𝑝𝐿 − 𝑝𝐿 𝑥𝐿 = 𝑞 1 − 𝑞 𝑝𝐿 − 𝑝𝐻 𝑥𝐻 + 1 − 𝑞 𝑞 𝑝𝐻 − 𝑝𝐿 𝑥𝐿 = 𝑞 1 − 𝑞 𝑝𝐻 − 𝑝𝐿 𝑥𝐿 − 𝑥𝐻 < 0 • So in the face of adverse selection. • Expected insurer profit is: 𝑞 𝜋 − 𝑝𝐻 𝑥𝐻 + 1 − 𝑞 𝜋 − 𝑝𝐿 𝑥𝐿 • The actuarially fair premium is equal to the probability of the bad state in the whole population. • In fact the more they charge.e. so the more they want to charge. 𝑞𝑝𝐻 + 1 − 𝑞 𝑝𝐿 . the bigger the gap between 𝑥𝐻 and 𝑥𝐿 . May lead to 𝑥𝐿 = 0.Adverse selection in insurance markets (5/5) • Suppose making the premium a function of the amount demanded is not feasible. i. ECO2051 – Intermediate Microeconomics . insurers will price above the actuarially fair level. causing inefficiency.

since they will both now face lower premiums (though the low risk type will not be as well off as if types were observable). premiums would be set to the actuarially fair level. in the UK we are all forced to buy the same amount of health insurance through taxes.g. ECO2051 – Intermediate Microeconomics . • Then the expression for profits with the actuarially fair premium from the last slides would be: 𝑞 1 − 𝑞 𝑝𝐻 − 𝑝𝐿 𝑥 ∗ − 𝑥 ∗ = 0 • So with free entry of insurers.Compulsory purchase • Suppose all agents were forced to buy 𝑥 ∗ units of insurance. • This may leave both high and low risk types better off. • E. • In the US many jobs come with health insurance bundled in.

Signalling and screening • Signalling occurs when the informed side of the market chooses to reveal something about their hidden characteristics.’ ECO2051 – Intermediate Microeconomics . • Another way of thinking of this is that the informed side of the market ‘self-selects. sellers of plums might like to offer warranties. • In our lemons model. • In order to contain information. • This would be too expensive for lemon sellers. 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.

pleasure travellers would not travel. ECO2051 – Intermediate Microeconomics . • If the price is over £20. • Business travellers prefer to be in London by 9. • If price is set at £20 or below firm wouldn’t be extracting maximum profit from business travellers. • This is a loss of welfare on both sides as marginal cost of an extra passenger (especially later in the day) is very low. • Business travellers are willing to pay £60.Signalling and price discrimination • Two types of train travellers from Portsmouth to London. • Pleasure travellers are willing to travel later therefore they will buy an off peak ticket if it’s cheaper.30. pleasure travellers are willing to pay £20.

• In this example the consumers are willingly revealing their types to the firm. • That consumers cannot engage in arbitrage.Price discrimination requires: • That the firm has some monopoly power. • That the firm can identify different types of consumer. • 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. ECO2051 – Intermediate Microeconomics .

• High productivity workers would clearly prefer to differentiate themselves if possible.Signalling and education • A firm wishes to hire workers. • High ability types may have higher opportunity costs though. high ability and low ability. • If productivity is observable then each worker is paid a wage equal to their marginal product. • Plausible that high ability types find the work easier. • Imagine productivity is not observable and there are two types of workers. ECO2051 – Intermediate Microeconomics . • If education is cheaper for them. • In this case the firm can only pay workers according to their expected productivity. then by obtaining education they can mark themselves as high ability.

Therefore individuals are happier with no university degree and more money No university degree University degree Years of education .Diagrammatic analysis of education as a signal earnings Taking education has a disutility.

so they’re willing to trade more money for less ed. IC is therefore steeper.Indifference curves are different for workers of different abilities low ability high ability Low ability person finds education harder. earnings No university degree University degree Years of education .

with 𝑐𝐻 < 𝑐𝐿 . • Suppose the able type can acquire education at a cost of 𝑐𝐻 and the less able type can acquire it at a cost 𝑐𝐿 .Education signalling (1/4) • Let 𝑎𝐻 be the productivity of the able type and 𝑎𝐿 be the productivity of the less able one. • Suppose there are 𝑞 able types in total. so in the absence of signalling the wage is given by 𝑞𝑎𝐻 + 1 − 𝑞 𝑎𝐿 . ECO2051 – Intermediate Microeconomics . (𝑎𝐻 > 𝑎𝐿 ).

i. • But as 𝑐𝐻 < 𝑐𝐿 high type people would strictly prefer this. 1 • Thus. • Thus for the firm’s offer to be sensible. • Acquiring this education would make sense for a low type if 𝑞𝑎𝐻 + 1 − 𝑞 𝑎𝐿 ≤ 𝑎𝐻 − 𝑐𝐿 𝑒 ⋄ . no one acquiring any education is not an equilibrium. it must be the case that 1 𝑒 ⋄ > 1 − 𝑞 𝑎𝐻 − 𝑎𝐿 . ECO2051 – Intermediate Microeconomics . • Does anyone have any incentive to deviate to acquiring some? • Imagine for the moment that a firm promised a wage of 𝑎𝐻 to anyone acquiring at least 𝑒 ⋄ units of education.e. so in a competitive market they would be paid 𝑎𝐻 . 𝑐𝐿 • Anyone acquiring more than 𝑐 1 − 𝑞 𝑎𝐻 − 𝑎𝐿 units of education in this 𝐿 situation would be unambiguously a high type. There is no “pooling” equilibria. if 𝑐𝐿 𝑒 ⋄ ≤ 1 − 𝑞 𝑎𝐻 − 𝑎𝐿 .Education signalling (2/4) • Suppose no one acquires any education.

• For a high type not to want to pretend to be a low type it must be the 𝑎 −𝑎 case that: 𝑎𝐻 − 𝑐𝐻 𝑒 ∗ > 𝑎𝐿 . i. and low types acquire none. • Then high types will be paid 𝑎𝐻 and low types will be paid 𝑎𝐿 . 𝑒 ∗ < 𝐻 𝐿. 𝑒 ∗ > 𝐻 𝐿 . i. 𝑐𝐻 • For a low type not to want to pretend to be a high type it must be the 𝑎 −𝑎 case that: 𝑎𝐿 > 𝑎𝐻 − 𝑐𝐿 𝑒 ∗ .e.Education signalling (3/4) • Suppose instead that high types acquire 𝑒 ∗ units of education. 𝑐𝐿 • Since 𝑐𝐻 < 𝑐𝐿 these inequalities may be satisfied simultaneously. ECO2051 – Intermediate Microeconomics .e. so there is a “separating” equilibria in which different types acquire different education levels.

g. • So e. • If instead we had assumed that 𝑐𝐻 > 𝑐𝐿 (high types find education more costly. income is lower for high types too. but the separating did not. • Income is trivially lower for low types. then we would have found the pooling equilibria existed. • The same output would be produced had no one acquired any education. ECO2051 – Intermediate Microeconomics .Education signalling (4/4) • The separating equilibria is inefficient since education is pure waste in this model. 𝑐𝐿 𝐿 so if 1 − 𝑐𝐻 𝑐𝐿 𝐿 𝐿 < 𝑞. income is 𝑎𝐻 − 𝑐𝐻 𝑒 ∗ < 𝑎𝐻 − 𝑐𝐻 𝑎𝐻 − 𝑎𝐿 = 1 − 𝑐𝐻 𝑎𝐻 + 𝑐𝐻 𝑎 . a high graduate tax may actually reduce inefficiency. 𝑐 𝑐 • For high types. perhaps due to better outside options).

• But in the presence of adverse selection it may be welfare improving. • Suppose that all agents value not being employed at 𝑣 times their productivity (where 0 < 𝑣 ≤ 1). ECO2051 – Intermediate Microeconomics . • This may be the value of watching TV.Education and adverse selection (1/3) • In the last model education signalling was unambiguously bad when high types find education easier than low types. or the value of the goods you could produce yourself without being employed.

with everyone working at firms. • But suppose 𝑣 > 𝑞 + 1 − 𝑞 𝑎𝐿 . • Thus without signalling. for a wage of 𝑎𝐿 . the wage would be 𝑞𝑎𝐻 + 1 − 𝑞 𝑎𝐿 as before. 𝑎𝐻 • Then high types prefer staying at home to earning a wage of 𝑞𝑎𝐻 + 1 − 𝑞 𝑎𝐿 in a firm.Education and adverse selection (2/3) • In the absence of signalling. ECO2051 – Intermediate Microeconomics . only low types work in firms.

ECO2051 – Intermediate Microeconomics .Education and adverse selection (3/3) • The deadweight loss (DWL) due to adverse selection is 1 − 𝑣 𝑎𝐻 . 𝑎𝐻 the DWL is roughly 1 − 𝑞 𝑎𝐻 − 𝑎𝐿 . signalling may be welfare improving under 𝑐𝐿 adverse selection. • With 𝑒 ∗ ≈ 𝑐 𝑎𝐻 −𝑎𝐿 𝑐𝐿 this DWL is roughly 𝑐𝐻 𝑐𝐿 𝑎𝐻 − 𝑎𝐿 . • So when 𝐻 < 1 − 𝑞. • When 𝑣 ≈ 𝑞 + 1 − 𝑞 𝑎𝐿 . • The DWL due to signalling is 𝑒 ∗ 𝑐𝐻 .

The meaning of inefficiency in an AI context • It’s not a lack of information that causes problems in the circumstances we have identified. not one with full information. ECO2051 – Intermediate Microeconomics . • This is the appropriate comparison. then the market could operate. • Outcomes which do not do this are inefficient. it’s the presence of asymmetric information. • Signalling improves efficiency because it makes the best use of the information available. • If neither party knew which cars were lemons.

most of the on-the-job business learning that employees do after college.” http://is. clients. how to write memos. such as how to dress well. might be skills that are mainly useful to signal innate features to bosses. • Distinguishing between the two theories is crucial for policy though. • Those with more education are more productive. In fact. • Education will be obtained early in life. . etc.Evaluating the signalling hypothesis • The human capital model states that education actually improves productivity. how to give presentations. • 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. ECO2051 – Intermediate Microeconomics • Education as “Learning to signal” makes it even harder to distinguish the signalling and the human capital views. co-workers. • Both models predict that: • Those with higher education will earn more. how to talk with clients. 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.

Tests of signalling / human capital • Signalling model assumes employers do not have full information. which put a value on accreditation. • Signalling model likely to be associated with ‘sheepskin’ effects. • Learning to signal better may account for the rest… ECO2051 – Intermediate Microeconomics . education likely to be less important when they have the opportunity to learn about productivity. • Manoli (2008) http://is. • Importance of education may go down over time. • Evidence in Varian suggests those years of education which lead to a certificate have a bigger impact on your suggests signalling accounts for up to 40% of the educational wage premium.

ECO2051 – Intermediate Microeconomics .In the next topic • We’ll discuss moral hazard. with a focus on insurance markets. • And we’ll introduce the principal-agent problem. another way of thinking about and solving moral hazard problems. • We’ll also use this framework to compare healthcare systems between the UK and the US.

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