Topic 12: Asymmetric

Information
(Chapter 38)

ECON 2350: Intermediate Micro II

Matias Cortes
Department of Economics, York University

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 Asymmetric Information
• Buyers and sellers may not have the same
information about goods involved in
transactions
• It may be costly or even impossible to gain
accurate information about the quality of
the goods being sold
• How are markets affected when there is
asymmetric information?

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 Example: Used Cars
• Based on the work of George Akerlof
(2001 Nobel Prize winner)
• 100 people want to sell their used card;
100 people want to buy a used car
• 50 cars are good quality (“plums”)
• 50 cars are bad quality (“lemons”)
• Asymmetric Information:
– Current owner of each car knows its quality;
prospective buyer does not
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• Owners of lemons want at least $1000
• Owners of plums want at least $2000
• Buyers are willing to pay $1200 for a
lemon; $2400 for a plum
• Without asymmetric information:
– Lemons will sell for a price between $1000
and $1200  buyer and seller both have a
surplus
– Plums will sell for a price between $2000 and
$2400  buyer and seller both have a surplus
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• With asymmetric information:
– Prospective buyers don’t know if a particular car is a
plum or a lemon
– They know there is a 50% chance of each
– They are willing to pay the expected value: 0.5 x
$1200 + 0.5 x $2400 = $1800
– But who is willing to sell a car for $1800?
– Only the owners of lemons!
– Then there is a 100% chance that the car is a lemon!
– Buyers adjust and are only willing to pay between
$1000 and $1200
– Only lemons are sold; no market for plums (even
though buyers are willing to pay for them!)

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 Quality Choice
• Suppose that each consumer wants to buy a single
umbrella
• There are 2 quality types
• High-quality umbrellas valued by consumers at $14
• Low-quality umbrellas valued by consumers at $8
• Asymmetric information: Consumers don’t know
quality of the umbrella that they are buying
• Both high and low quality umbrellas cost $11.50 to
manufacture
• The market is perfectly competitive
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• Case 1: only low-quality umbrellas are
produced
– Consumers are willing to pay $8
– But umbrellas cost $11.50 to produce
– So none are sold

• Case 2: only high-quality umbrellas are

produced
– Consumers are willing to pay $14
– Marginal cost is $11.50
– Competitive equilibrium implies p=MC=11.50
– Consumers get surplus
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• Case 3: Both qualities are produced
– Because of competition, p=MC=11.50
– Consumer’s expected value (price they are
willing to pay) if the fraction of high-quality
umbrellas in the market is q is: 14q + 8(1-q)
– The market will operate only if
14𝑞𝑞 + 8 1 − 𝑞𝑞 ≥ 11.50
– This is satisfied if q is at least 7/12
– For this market to be sustainable, at least
7/12 of the umbrellas in the market must be
high-quality
– Consumer surplus will be higher if q is higher
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• Now suppose that it costs $11 to produce a low-
quality umbrella; $11.50 to produce a high-quality
one
• If the market price is $11.50, producers of high-
quality umbrellas make zero profit; producers of
low-quality umbrellas make profit of $0.50 per
umbrella
• If producers can choose what type of umbrella to
produce, they would all choose to produce low
quality ones
• The consumers will realize this and will only be
willing to pay $8
• But this is less than the marginal cost, so no
umbrellas of either quality will be produced or sold!
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 Adverse Selection
• An insurance company wants to offer insurance
for bicycle theft
• In some areas, there is a high probability that a
bike is stolen; in others the probability is low
• The insurance company decides to offer the
insurance based on the average theft rate
• Who is going to buy the insurance?
• Only people in the high theft areas!
• The group that chooses to buy insurance is not
representative; it is “adversely selected”
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• Similarly, health insurance companies
cannot base their rates on the average
incidence of health problems
• They can only base their rates on the
average incidence among the group of
potential purchasers
• Since this group is adversely selected, the
rates must be high
• This further pushes out the low-risk
individuals

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• Requiring everyone to purchase insurance
might make everyone better off
• The high-risk people are better off
because they get better rates
• The low-risk people can now get coverage
• We usually think that more choice is
better, but in this situation, restricting
choice can result in a Pareto
improvement

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 Moral Hazard
• Suppose that the probability of bike theft is the
same in all areas, but depends on the actions
taken by individuals (e.g. do they use a good
bike lock)
• If no insurance is available, consumers have an
incentive to take actions that protect the bike
(e.g. investing in a good bike lock)
• But if a consumer can insure the bike, then they
have no (or much less of an) incentive to take
care of the bike
• As a result, the risk of having it stolen rises!

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• If the precautions taken by the consumer
can be observed, the insurance company
can base its rates on this
– For example, lower rates for health insurance
for non-smokers relative to smokers
• But insurance companies cannot condition
their rates on every possible action of the
consumer
• To give incentives to the consumer to take
precautions, policies generally have a
deductible (so that it “hurts” the consumer
a bit if the bad event happens)
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• Unlike in a standard competitive market,
here the consumers would like to buy
more insurance and the insurance
company would be willing to provide more
insurance if the consumers did not change
their actions
• But this trade won’t occur because if the
consumers were able to purchase more
insurance, they would rationally change
their actions and take fewer precautions!

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 Summary
• Moral Hazard: one side of the market can’t
observe the actions of the other
– Leads to rationing: firms would like to provide more
than they do, but they are unwilling to do so since it
will change the incentives of their consumers

• Adverse Selection: one side of the market can’t

observe the “type” or quality of the other
– Leads to too little trading: the market for the “good”
types may fail to exist

• When there is asymmetric information,

outcomes will be inefficient relative to the
equilibrium with full information
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 Signaling
• Suppose that we have two types of
workers:
– A fraction b of all workers are “high ability”:
marginal product aH
– A fraction 1-b of all workers are “low ability”:
marginal product aL<aH
• If worker quality were perfectly observable,
firms would offer wages equal to marginal
product

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• If a firm can’t distinguish the worker types, they
would offer the expected marginal product:
w=(1-b) aL+ baH
• Low types earn more than their marginal
product; high types earn less than their marginal
product (but may still be willing to work at this
wage)
• Now suppose that the workers can choose to
obtain a higher education degree
• For simplicity, suppose that getting this degree
does not affect their productivity at all
• Suppose that the cost of acquiring education is
different for high and low ability types
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• Consider a scenario in which high ability types
acquire education and low ability types do not
• Even though education does not increase
productivity, firms can now use education as a
signal to identify the worker type
• They pay individuals with higher education a
wage aH and individuals with no education a
wage aL
• To see if this is an equilibrium, we need to
determine whether either type of worker has an
incentive to deviate (change their choice of
whether to get education or not)

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• If low ability types acquire education:
– Their wages increase from aL to aH
– They incur a cost equal to cL
– They will have no incentive to acquire education if
𝑎𝑎𝐻𝐻 − 𝑎𝑎𝐿𝐿 < 𝑐𝑐𝐿𝐿
• For high ability types, it makes sense to acquire
education as long as:
𝑎𝑎𝐻𝐻 − 𝑎𝑎𝐿𝐿 > 𝑐𝑐𝐻𝐻
• If:
𝑐𝑐𝐻𝐻 < 𝑎𝑎𝐻𝐻 − 𝑎𝑎𝐿𝐿 < 𝑐𝑐𝐿𝐿 ,
then both conditions hold!

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• This type of equilibrium is known as a
separating equilibrium: the two types
“distinguish” or “separate” themselves
from each other

• Education serves as a signal of ability,

even though it does not make any
difference for productivity
– The money spent on education is “wasted”
from a societal point of view
– But it addresses the asymmetric information
problem by allowing the high ability workers to
signal their type and increase their wages
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• Suppose, however, that the condition:
𝑐𝑐𝐻𝐻 < 𝑎𝑎𝐻𝐻 − 𝑎𝑎𝐿𝐿 < 𝑐𝑐𝐿𝐿 ,
does not hold

• Then we would have a pooling

equilibrium
– No workers would invest in education
– The firm cannot distinguish the two worker
types, so all workers receive the same wage

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 Recap
• Imperfect or asymmetric information can
have dramatic effects on market outcomes
• Adverse selection refers to situations
where an agent or product’s type is not
observable by the other side of the market
• Generally, too little trade takes place in
markets with adverse selection
• Everyone might be made better off by
forcing them to transact

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 Recap
• Moral hazard refers to situations where one side
of the market can’t observe the actions of the
other side
• This generally leads to rationing
• When adverse selection or moral hazard are
present, some agents will want to invest in
signals to provide information about their type
• In a separating equilibrium, different agent types
are able to distinguish themselves from each
other
• In a pooling equilibrium, all agent types are
pooled together
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