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Chapter

Nineteen
Asymmetric
Information

Topics
ƒ Problems Due to Asymmetric
Information.
ƒ Responses to Adverse Selection.
ƒ How Ignorance About Quality Drives
Out High-Quality Goods.
ƒ Price Discrimination Due to False
Beliefs About Quality.
ƒ Market Power from Price Ignorance.
ƒ Problems Arising from Ignorance
When Hiring.
© 2009 Pearson Addison-Wesley. All rights reserved.

19-2

Problems Due to Asymmetric
Information
ƒ adverse selection - opportunism
characterized by an informed person’s
benefiting from trading or otherwise
contracting with a less-informed person
who does not know about an
unobserved characteristic of the
informed person

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19-3

1

Problems Due to Asymmetric
Information
ƒ moral hazard - opportunism
characterized by an informed person’s
taking advantage of a less informed
person through an unobserved action

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19-4

Controlling Opportunistic Behavior
Through Universal Coverage
ƒ Adverse selection can be prevented if
informed people have no choice.
Š A government can avoid adverse selection
by providing insurance to everyone or by
mandating that everyone buy insurance.

© 2009 Pearson Addison-Wesley. All rights reserved.

19-5

Equalizing Information
ƒ screening - an action taken by an
uninformed person to determine the
information possessed by informed
people.
ƒ signaling - an action taken by an
informed person to send information to
an uninformed person.

© 2009 Pearson Addison-Wesley. All rights reserved.

19-6

2

All rights reserved.Lemons Market with Fixed Quality ƒ When buyers cannot judge a product’s quality before purchasing it. Š Some cars —lemons— have a variety of insidious problems that become apparent to the owner only after the car has been driven for a while. © 2009 Pearson Addison-Wesley. Š The seller of a used car knows from experience whether the car is a lemon. Š We assume that the seller cannot alter the quality of the used car © 2009 Pearson Addison-Wesley. 19-7 Lemons Market with Fixed Quality ƒ Cars that appear to be identical on the outside often differ substantially in the number of repairs they will need. © 2009 Pearson Addison-Wesley. low-quality products—lemons—may drive highquality products out of the market. All rights reserved. All rights reserved.000 for a lemon and $2. 19-8 Lemons Market with Fixed Quality ƒ Suppose that there are many potential buyers for used cars. Š All are willing to pay $1.000 for a good used car. 19-9 3 .

$ (a) Market for Lemons e S2 1. $ Price of a good ca r.750 DL F DG D* S1 750 0 1.000 0 0 Good cars per year Lemons per year 19-10 © 2009 Pearson Addison-Wesley. All rights reserved.250 1. $ (b) Ma rket for Good Cars DG 2.000 owners of good cars are willing to sell.Figure 19. Lemons Market with Fixed Quality ƒ 1.000. Š The reservation price of owners of lemons— the lowest price at which they will sell their cars—is $750. 19-11 © 2009 Pearson Addison-Wesley. All rights reserved.000 Good cars per year 19-12 4 .000 1.1 Markets for Lemons and Good Cars 1. 0 1.500 (b) Ma rket for Good Cars SL f D* Price of a good ca r.000 Lemons per year © 2009 Pearson Addison-Wesley.000 E 2. $ Price of a lemon.500 1. which is less than $2.000 DL 1. ƒ The reservation price of owners of highquality used cars is v.000 owners of lemons and 1. Figure 19. All rights reserved.1 Markets for Lemons and Good Cars (a) Market for Lemons Price of a lemon.

© 2009 Pearson Addison-Wesley. 19-15 5 .Lemons Market with Fixed Quality ƒ If both sellers and buyers know the quality of all the used cars before any sales take place. both types of cars sell for the same price. and good cars sell for more than lemons. All rights reserved. all the cars are sold. This market is efficient because the goods go to the people who value them the most. Š The expected value of a used car is © 2009 Pearson Addison-Wesley. Š If no one can tell a lemon from a good car at the time of purchase. All the cars are sold if everyone has the same information © 2009 Pearson Addison-Wesley. All rights reserved. 19-14 Lemons Market with Fixed Quality ƒ Suppose that everyone is risk neutral and no one can identify the lemons: Buyers and sellers are equally ignorant. All rights reserved. 19-13 Lemons Market with Fixed Quality ƒ The amount of information they have affects the price at which the cars sell. Š A buyer has an equal chance of buying a lemon or a good car.

Lemons Market with Fixed Quality ƒ This market is efficient because the cars go to people who value them more than their original owners.500. 19-17 Asymmetric Information. All rights reserved. © 2009 Pearson Addison-Wesley. All rights reserved. © 2009 Pearson Addison-Wesley. Š The equilibrium in this market depends on whether the value that the owners of good cars place on their cars. Sellers of good-quality cars are implicitly subsidizing sellers of lemons. or Š only lemons sell for a price equal to the value that buyers place on lemons. 19-18 6 . this market may be inefficient: Š The better-quality cars may not be sold even though buyers value good cars more than sellers do. is greater or less than the expected value of buyers. $1. ƒ If sellers know the quality but buyers do not. 19-16 Asymmetric Information. All rights reserved. ƒ There are two possible equilibria: Š All cars sell at the average price. © 2009 Pearson Addison-Wesley. v.

19-19 Asymmetric Information.000 0 Lemons per year 1. Š Sellers of lemons benefit and sellers of good cars suffer from consumers’ inability to distinguish quality.000. © 2009 Pearson Addison-Wesley. © 2009 Pearson Addison-Wesley.Figure 19.000 Good cars per year © 2009 Pearson Addison-Wesley.500 1.000 S2 1. Š Consequently. All rights reserved. asymmetric information does not cause an efficiency problem. Š but it does have equity implications.750 DL DG F D* S1 750 0 1. Š Buyers realize that. and no good cars change hands.000 lemons sell for the expected (and actual) price of $1.500 (b) Ma rket for Good Cars SL f D* Price of a good ca r.500. 19-21 7 . ƒ Now suppose that the sellers of good cars place a value of v = $1.1 Markets for Lemons and Good Cars 1.750 on their cars and thus are unwilling to sell them for $1. All rights reserved. Š As a result. ƒ Consequently.250 e E 2. 19-20 Asymmetric Information.750. the lemons drive good cars out of the market. the 1. in equilibrium. $ (a) Market for Lemons 1.000 1. they can buy only lemons. $ Price of a lemon. All rights reserved. at any price less than $1.

All rights reserved. All rights reserved.000)].000.The share of current owners who have lemons is θ [in our previous example.750. © 2009 Pearson Addison-Wesley. Š The five firms in the market produce 100 bags each.000 and good used cars at $2. the share was θ = 1 2 = 1. Š A firm produces only high-quality or only lowquality bags. For what values of θ do all the potential sellers sell their used cars? Describe the equilibrium.Asymmetric Information.000 + 1. Š there are no repeat purchases. and Š consumers value the bags at their cost of production. All rights reserved. 19-23 Lemons Market with Variable Quality ƒ Suppose that it costs $10 to produce a lowquality book bag and $20 to produce a highquality bag. © 2009 Pearson Addison-Wesley.1 ƒ Suppose that everyone in our used-car example is risk neutral. Š consumers cannot distinguish between the products before purchase. and the reservation price of owners of high-quality used cars is $1. 19-22 Solved Problem 19. © 2009 Pearson Addison-Wesley. ƒ This equilibrium is inefficient because high-quality cars remain in the hands of people who value them less than potential buyers do. 19-24 8 . potential car buyers value lemons at $1. the reservation price of lemon owners is $750.000/(1.

the firms do not produce high-quality goods even though consumers are willing to pay for the extra quality. due to asymmetric information. all firms benefit because the bags sell for $12 instead of $10. if one firm raises the quality of its product. 19-26 Limiting Lemons ƒ ƒ ƒ ƒ ƒ Laws to Prevent Opportunism. 19-25 Lemons Market with Variable Quality ƒ Because the high-quality firm incurs all the expenses of raising quality. and reaps only a fraction. © 2009 Pearson Addison-Wesley.Lemons Market with Variable Quality ƒ If one firm makes a high-quality bag and all the others make low-quality bags. All rights reserved. $10 extra per bag. the expected value per bag to consumers is Š Thus. All rights reserved. © 2009 Pearson Addison-Wesley. Standards and Certification. Signaling by Firms. All rights reserved. it opts not to produce the high-quality bags. 19-27 9 . ƒ Therefore. $2. Consumer Screening. Third-Party Comparisons. of the benefits. © 2009 Pearson Addison-Wesley.

Price Discrimination Due to False Beliefs About Quality ƒ One way in which firms confuse consumers is to create noise by selling virtually the same product under various brand names. p*. All rights reserved. Š Thus. one store can charge more than others and not lose all its customers. Š Customers who do not know that the product is available for less elsewhere keep buying from the high-price store. 19-29 Market Power from Price Ignorance ƒ If consumers have limited information about the price that firms charge for a product. © 2009 Pearson Addison-Wesley. All rights reserved. all stores charge the full-information competitive price. © 2009 Pearson Addison-Wesley. All rights reserved. each store faces a downward-sloping residual demand curve and has some market power. Š If consumers have full information about prices. 19-30 10 . the store would lose all its business. © 2009 Pearson Addison-Wesley. Š If one store were to raise its price above p*. 19-28 Market Power from Price Ignorance ƒ Suppose that many stores in a town sell the same good. Š Each store faces a residual demand curve that is horizontal at the going market price and has no market power.

Your bus will leave very soon. determining which shop has the lowest price won’t be useful to you in the future because you do not intend to return anytime soon. © 2009 Pearson Addison-Wesley. There are many tourists in your position. All rights reserved. 19-33 11 . 19-32 Tourist-Trap Model ƒ It costs each tourist c in time and expenses to visit a shop to check the price or buy a snowy. Š If you go to two souvenir shops before buying at the second shop. you see that it sells the town’s distinctive snowy: a plastic ball filled with water and imitation snow featuring a model of the Donner Party. the cost of the snowy is p + 2c. All rights reserved. so you can’t check the price at each shop to find the lowest price. All rights reserved. but the guidebook does not state the price at any particular shop. Š Thus. © 2009 Pearson Addison-Wesley. 19-31 Tourist-Trap Model ƒ Let’s assume that you and other tourists have a guidebook that reports how many souvenir shops charge each possible price for the snowy. You instantly decide that you must buy at least one of these tasteful mementos— perhaps more if the price is low enough. if the price is p. © 2009 Pearson Addison-Wesley. each with an identical demand function. the cost of buying a snowy at the first shop you visit is p + c.Tourist-Trap Model ƒ You arrive in a small town near the site of the discovery of gold in California. Moreover. Souvenir shops crowd the street. Wandering by one of these stores.

an equilibrium in which all firms charge the full-information. © 2009 Pearson Addison-Wesley. a small positive number. ƒ Will all souvenir shops charge the same price? Š If so. © 2009 Pearson Addison-Wesley. what price will they charge? © 2009 Pearson Addison-Wesley. All rights reserved. 19-36 12 . ƒ If consumers have limited information about price. All rights reserved. Š where ε. 19-35 Monopoly Price. competitive price is impossible. All rights reserved. ƒ Can there be an equilibrium in which all stores charge the same price and that price is higher than the competitive price? Š The monopoly price may be an equilibrium price. is the shop’s price markup. a firm can profitably charge p1 = p* + ε.When Price Is Not Competitive. 19-34 When Price Is Not Competitive. ƒ If all other shops charge p*.

can there be a single-price equilibrium at a price less than pm? © 2009 Pearson Addison-Wesley. All rights reserved. 19-37 Solved Problem 19. each of which charges pm (because consumers do not know the shops’ prices). © 2009 Pearson Addison-Wesley. and buyers’ search costs are c. 19-39 13 . there are many souvenir shops.Monopoly Price. the only possible single-price equilibrium is at the monopoly price. 19-38 Information About Employment Risks ƒ Firms typically have more information than workers about job safety. All rights reserved. When consumers have asymmetric information and when search costs and the number of firms are large. If the government pays for half of consumers’ search costs.2 ƒ Initially. Š This asymmetric information may lead to less than optimal levels of safety © 2009 Pearson Addison-Wesley. All rights reserved.

All rights reserved. 19-41 Cheap Talk ƒ When an informed person voluntarily provides information to an uninformed person. ƒ Safety investments by one firm provide an externality to other firms: Š That firm’s lower incidence of accidents reduces the wage that all firms in the industry must pay. All rights reserved. Š Because each firm bears the full cost of its safety investments but derives only some of the benefits. © 2009 Pearson Addison-Wesley. 19-40 Table 19. 19-42 14 . Š Extra safety is costly. the firms underinvest in safety. the informed person engages in: Š cheap talk .unsubstantiated claims or statements © 2009 Pearson Addison-Wesley. All rights reserved.Information About Employment Risks ƒ Each firm must consider how safe to make its plant.1 Safety Investment Game © 2009 Pearson Addison-Wesley.

All rights reserved.2 Employee-Employer Payoffs © 2009 Pearson Addison-Wesley. Š The undemanding job can be done better by someone of low ability because the job bores more able people.5 ⎝2 ⎠ ⎝2 ⎠ © 2009 Pearson Addison-Wesley. Š The demanding job requires someone with high ability. All rights reserved.5 ⎝2 ⎠ ⎝2 ⎠ ƒ if it gives her the undemanding job and ⎛1 ⎞ ⎛1 ⎞ ⎜ × 2 ⎟ + ⎜ × 1⎟ = 1. who then perform poorly.Cheap Talk ƒ Suppose that a firm plans to hire Cyndi to do one of two jobs. © 2009 Pearson Addison-Wesley. All rights reserved. 19-44 Cheap Talk ƒ The firm’s expected payoff is ⎛1 ⎞ ⎛1 ⎞ ⎜ × 1⎟ + ⎜ × 4 ⎟ = 2. 19-43 Table 19. 19-45 15 .

© 2009 Pearson Addison-Wesley.Education as a Signal ƒ If high-ability people are more likely to go to college than low-ability people. 19-46 Education as a Signal ƒ Extreme assumptions that Š graduating from an appropriate school serves as the signal and Š that schooling provides no training that is useful to firms ƒ High-ability workers are θ share of the workforce. 19-48 16 . All rights reserved. 19-47 Education as a Signal ƒ pooling equilibrium . and low-ability workers are 1 − θ share. ƒ Employers pay all workers the average wage: w = θ wh + (1 − θ ) wl © 2009 Pearson Addison-Wesley. and that of a low-ability worker is wl (over their careers). All rights reserved.an equilibrium in which dissimilar people are treated (paid) alike or behave alike. ƒ The value of output that a high-ability worker produces for a firm is worth wh. schooling signals ability to employers © 2009 Pearson Addison-Wesley. All rights reserved.

Education as a Signal ƒ We assume that Š high-ability individuals can get a degree by spending c to attend a school and Š that low-ability people cannot graduate from the school © 2009 Pearson Addison-Wesley. 19-51 17 . All rights reserved. 19-49 Education as a Signal ƒ separating equilibrium .an equilibrium in which one type of people takes actions (such as sending a signal) that allows them to be differentiated from other types of people © 2009 Pearson Addison-Wesley. Š high-ability people pay c to get a degree and are employed at a wage of wh. All rights reserved. Š while low-ability individuals do not get a degree and work for a wage of wl. © 2009 Pearson Addison-Wesley. All rights reserved. 19-50 Education as a Signal ƒ In a separating equilibrium.

All rights reserved.Education as a Signal ƒ Rearranging terms in the previous expression. 19-52 Pooling Equilibrium. 19-54 18 . for what values of θ is a pooling equilibrium possible? © 2009 Pearson Addison-Wesley. © 2009 Pearson Addison-Wesley. 19-53 Solved Problem 19. ƒ In a pooling equilibrium. and wl = $20. we find that a high-ability person chooses to get a degree if wh − wl > c.000. all workers are paid the average wage.000. All rights reserved. the extra pay is less than the cost of schooling: wh − w < c © 2009 Pearson Addison-Wesley. All rights reserved.3 ƒ For what values of θ is a pooling equilibrium possible in general? In particular. if c = $15. ƒ It does not pay for the high-ability person to graduate if the benefit from graduating.000. wh = $40.

Unique or Multiple Equilibria. ƒ In our example of a separating equilibrium. the cost of schooling. © 2009 Pearson Addison-Wesley. © 2009 Pearson Addison-Wesley. ƒ Signaling changes the distribution of wages: Š Instead of everyone getting the average wage. high-ability people get an otherwise useless education solely to show that they differ from low-ability people. All rights reserved. and the share of highability workers. 19-55 Figure 19. high-ability workers receive more pay than low-ability workers. All rights reserved. ƒ Depending on differences in abilities. All rights reserved. only one type of equilibrium may be possible or both may be possible. 19-57 19 . 19-56 Efficiency.2 Pooling and Separating Equilibria © 2009 Pearson Addison-Wesley.

All rights reserved. 19-59 Screening in Hiring ƒ Firms screen prospective workers in many ways. © 2009 Pearson Addison-Wesley. Š Interviews and Tests. All rights reserved. 19-58 Efficiency. Š Statistical Discrimination © 2009 Pearson Addison-Wesley. 19-60 20 . Total social output falls with signaling if signaling is socially unproductive but may rise with signaling if signaling also raises productivity or serves some other desirable purpose.2 Pooling and Separating Equilibria © 2009 Pearson Addison-Wesley. All rights reserved.Figure 19.

Figure 19. All rights reserved.3 Statistical Discrimination © 2009 Pearson Addison-Wesley. 19-61 21 .