Economics of Information

(ECON3016)
Presentation and Introduction

The instructor

Lecturer: Dr. Konrad Mierendorff

Office: Drayton House, 105
Office hours:

normally: Tu 14-15 or by appt.

until reading week: Tu 15:30-16:30
outside the teaching period: email!

Role of Information in
Economics

Pareto efficiency of exchange under

complete information
Price system reduces info requirement

Only need to know own preferences and prices

to see which transactions are beneficial
First Welfare Theorem

First Step: Introduce symmetric incomplete

information about goods traded

e.g. trade of a financial asset (w/o insiders!)

First Welfare Theorem still holds.

Asymmetric Information I

What happens if information is incomplete

but some traders know more than others?

e.g.: good and bad assets (or many types)

Only a subset of traders is informed
The uninformed cant distinguish good and bad
There is no hard/credible evidence

For given price: Only bad assets are traded

Assets on the market are an adverse selection

from the whole pool of assets

Adverse Selection

For given price: Only bad assets are traded

Buyers are unwilling to pay high prices for
bad selection of assets
At low prices, less and less asset qualities
are offered on the market.

Lack of hard evidence prevents charging

different prices for different assets

Can lead to complete freeze of trade even if

traders would be willing to trade under
complete information.

Asymmetric Information II

What happens if information is symmetric

initially but becomes asymmetric during a
relationship?

Example: Employment contract where effort is

not verifiable
Employee (the agent) knows effort
No hard evidence available that can prove effort
provided
Employer (the principal) may know effort but
cannot go to court for lack of hard evidence.

Moral Hazard

Fixed wage does not provide incentive to

provide high effort

What contractual arrangements will be used

to increase gains from relationship?

Agent will shirk (Moral Hazard) because

Principal cannot prove breach of contract that
demands high effort
Effort can be inefficiently low

Performance-based payment, bonus,

Can we reach full efficiency?

Asymmetric Information III

What happens if the informed party can

produce hard evidence (at some cost)?
Example: Labour market

Initially, quality of a worker is not verifiable and

only know to worker
Assume that there is no adverse selection:

There exists a wage that firms are willing to pay for an

average worker (by assumption)
All workers are willing to work for this wage (by asspt)

Efficient trade is possible despite asymmetric

information. (BUT!!!)

Signalling

High quality workers are willing to incur

cost to signal their quality

Example: Difficult degree that is easier to

obtain for high quality workers.
They will do so even if this does not
increase their productivity.
A degree is a credible signal of high
quality and leads to higher wage
Signalling can decrease efficiency!

Other terms for Economics of

Information (EI)

You might also hear EI being referred

to as:

Contract Theory

Agency Theory

Summary

Markets in which one or both sides are

imperfectly informed are markets with
Imperfect Information.
Imperfectly informed markets in which one
side is better informed than the other are
markets with Asymmetric Information (AI).
Note: We study a conflict of interest

Without conflict, the better informed party would

be willing to reveal the information

Summary

When AI is present, if participants have opposing

objectives, it is natural to think that:

The more informed party will act in a way so as to benefit

from her informational advantage
The less informed party will also act in a way so as to
overcome her informational disadvantage
These actions will have implications for the contracts that
they agree to sign
This will have consequences on the efficiency and
existence of the market
The existence of markets and their efficiency are important
topics in economics

Summary

Moral Hazard

Information is symmetric before the contract is

accepted but asymmetric afterwards

Two cases of moral hazard:

The agent will carry out a non verifiable action

after the signature of the contract (hidden action)
During the relationship, the agent learns more
than the principal about an important variable
(ex post hidden information)

Summary

Examples of Moral Hazard:

Salesman effort (hidden action)

Effort to drive alert (hidden action)
Effort to diagnose an illness (hidden
action)
Manager is better informed than owner
about which is the most appropriate
strategy for the market conditions (ex
post hidden information)

Summary

Adverse Selection

Arises in standard market settings:

Information is asymmetric before the contract is

signed
Sometimes called ex-ante hidden information
Seller has information about a good (quality) that
affects both his and the buyers preferences.

In Principal-Agent settings:

Workers of different productivity

Summary

Examples of Adverse Selection

Medical insurance: healthy and unhealthy

customers (even if there are tests, they
might be too costly/not fully informative)
Car Insurance: Drivers that enjoy speed
and drivers that dislike speed
Highly or poorly motivated workers
Salesman with a high or low disutility of
effort

Summary

Signalling

Ex-ante hidden information as in markets

with adverse selection
Informed party can credibly signal her
information (e.g. quality)

Example: Education as a signal of

worker quality

Summary: Main Questions

Which trades, types of contracts,

institutions & behavior that will emerge
in equilibrium?

Asymmetric Information
Conflict of Interest

Implications for the Efficiency and

Existence of Markets

Summary: Examples

AI is present in many markets: labour, health,

insurance, agriculture, regulation
How should a worker be paid? Why are some
workers paid a fixed salary and others receive a
compensation that depends on their results?
How should a business be organized? What are the
advantages and disadvantages of delegation?
How should unemployment insurance be designed?
What about health insurance?
What about income taxation?
Why do some business offer a menu of contracts?
I.e. phones...

Nobel Prizes

1996 James Mirrlees and

William Vickrey

2001: George Akerlof,

Michael Spence, and
Joseph Stiglitz

2007 to Lenoid Hurwicz,

Eric Maskin and Roger
Myerson

Syllabus: Parts 1 to 7

Part 1: Presentation and overview (this one)

Part 2: Review Decision Theory under Uncertainty (Read
your microeconomics book from last year)
Part 3-6: Theory of Economics of Information.

Most relevant book: Macho-Stadler, I. and Prez-Castrillo, J.D.

An Introduction to the Economics of Information. Incentives and
Contracts. Oxford University Press. 2001. Second edition.

The book includes solutions to many exercises

Part 7: The empirical relevance of incentives and
asymmetric information

Development
Insurance
Health economics
The reading list for this part might change.