Price Theory

Lecture 11: Information Economics

 Topics for today's lecture . . .

1. Market unravelling

2. Signalling

3. Contracting
Market unravelling
 The market for health insurance
Health insurance compensates an individual for the costs
incurred when receiving medical care.
The likelihood that an individual will require medical attention
varies from person to person.
• Factors that influence the risk that a person will require
medical care include age, medical history, family medical
history, and lifestyle.
In many jurisdictions, insurance companies must offer health
insurance at the same price to all consumers.
• In these jurisdictions, the fair price of health insurance
depends on the average risk of the insured population.
 The (potential) consumers of
health insurance
Consumer p
Suppose that five consumers are
George 0.2 •  
Tom 0.4
in the market for health insurance.
Theo 0.6
• Each consumer has an income
Abe 0.8
of $90,000.
Don 1.0
• The cost of medical care is
$80,000.
• Each consumer's utility
function is U =
Consumers differ in the
probabilities that they will require
medical care.
 Willingness to pay for health
insurance
Consumer p EV RP WTP
Using the methods we
George 0.2 $74k $6.4k $22.4k
developed in lecture 4, we can
Tom 0.4 $58k $9.6k $41.6k
calculate for each consumer,
Theo 0.6 $42k $9.6k $57.6k
Abe 0.8 $26k $6.4k $70.4k • the expected value of the
Don 1.0 $10k $0.0k $80.0k lottery he faces.
• his risk premium.

Using these values, we can

derive each consumer's
willingness to pay for health
insurance.

Note: You should check the

calculations on this slide.
 Exercise: Expected payouts
Consumer p WTP
George 0.2 $22.4k
Recall that the cost of
Tom 0.4 $41.6k
medical care is $80,000.
Theo 0.6 $57.6k 1. Calculate the expected
Abe 0.8 $70.4k payout for each
Don 1.0 $80.0k consumer.
2. How does each
consumer's willingness to
pay compare to his
expected payout?
The fair price of health insurance
The fair price of a health insurance policy is the average of
•  
the expected payouts for the consumers who purchase the
policy.
If all five consumers buy the policy, the fair price is,

The fair price is significant because it just covers the

expected cost of the insurance policies to the insurer.
Note: Recall that, in reality, the fair price is less than the
insurer's total cost of doing business as it does not cover the
insurer's operating costs. We will ignore this for the purposes
of the present example.
 Unravelling
Consumer p WTP EP
If the insurer offers policies at a
George 0.2 $22.4k $16.0k
price of $48,000, George and
Tom 0.4 $41.6k $32.0k
Tom will not purchase.
Theo 0.6 $57.6k $48.0k
Abe 0.8 $70.4k $64.0k • The price exceeds their
Don 1.0 $80.0k $80.0k respective willingness to
pay.

If George and Tom do not

purchase, the insurer requires
a higher price to break even.
• This is because George and
Tom have the lowest
expected payouts.
 Further unravelling
Consumer p WTP EP
If Theo, Abe and Don purchase
George 0.2 $22.4k $16.0k
policies, the fair price is
Tom 0.4 $41.6k $32.0k
$64,000.
Theo 0.6 $57.6k $48.0k
Abe 0.8 $70.4k $64.0k • This price exceeds Theo's
Don 1.0 $80.0k $80.0k willingness to pay.

If only Abe and Don purchase,

the fair price is $72,000.
• This price exceeds Abe's
willingness to pay.

If Don alone purchases a

policy, the fair price is $80,000;
exactly his willingness to pay.
 Definition: Adverse selection
A phenomenon whereby an individual's behaviour in a market
depends on their private information, to the detriment of
uninformed market participants.

In insurance markets, one consequence of adverse selection

is that an increase in the insurance premium increases the
overall riskiness (average expected payout) of the pool of
individuals who purchase an insurance policy.
 Universal health care (1)
In many nations, governments pursue the objective of universal
health care.

• With universal health care, every citizen is insured against the

cost of medical treatment.

• The average expected payout is held down by the inclusion of

all citizens in the pool of insured individuals.
 Universal health care (2)
Broadly speaking, there are two methods for achieving universal
health care:

Government provision: The government provides health

insurance (sometimes called health coverage) to all citizens,
financing the costs through taxation.

Government mandate: The government requires all citizens to

purchase health insurance (regardless of willingness to pay),
providing subsidies to citizens who would otherwise be unable to
afford the premiums.
 Quiz 1

Consu p WTP EP Theo and Abe are in the

mer
market for health insurance.
Theo 0.6 $57.6k $48.0k
If an insurer offers policies
Abe 0.8 $70.4k $64.0k
with a premium of $57k then,

a) neither consumer will purchase a policy.

b) only Abe will purchase a policy, and the premium is greater than
the fair price.
c) both consumers will purchase a policy, and the premium is
lower than the fair price.
d) both consumers will purchase a policy, and the premium is
greater than the fair price.
 Quiz 2
Which of the following statements is false?
a) Market unravelling is one possible consequence of
adverse selection.
b) A government mandate requiring consumers to purchase
an insurance policy raises the willingness to pay of
individuals with the lowest expected payouts.
c) A risk averse consumer's willingness to pay for health
insurance increases as her/his risk of illness or injury
increases.
d) Market unravelling does not occur when health insurance
is provided by the Government.
 The market for lemons (1)
Adverse selection, and market unravelling, can also arise
when sellers have private information.
• Sellers typically know more about the quality of the
products they sell than buyers, and have an incentive to
overstate the quality.
• An example can be found in the exercise for this topic.
 The market for lemons (2)
There are a number of method by which governments may
address the problem of market unravelling.
Standards & information disclosure: The government can
mandate that products are produced to minimum standards,
and require sellers to reveal significant information to buyers.
Guarantees & consumer protections: The government can
require sellers to guarantee the quality and performance of
their products.
Signalling
 Adverse selection in the
labour market
A worker's productivity depends, at least in part, on her/his
level of ability (or talent).
• When a worker first seeks employment, her/his level of
ability is private information; not directly observable by
prospective employers.
Employers are willing to pay higher wages to workers with
high ability (and therefore a high marginal product of labour).
• Thus a worker has an incentive to overstate her/his ability.

Knowing this, an employer will only offer higher wages to

workers who provide a credible signal of having a high level
of ability.
 Definition: Signalling

An action taken by an individual with private information,

which credibly conveys the information to uninformed parties.

For a signal to be credible, an individual must not be willing

to send the signal if it is more favourable than her/his private
information.
A labour market with two types
of worker
Suppose that there are two types of worker in the labour market,
•
high  ability and low ability.
• If an employer cannot determine a worker's level of ability,
she/he receives a wage of $40,000.
• A worker who is identified as high ability receives wage of
$90,000.

The utility that a worker derives from a wage w is U =

• In this equation, c is the disutility a worker incurs if she/he
sends a signal of high ability.

A university degree may serve as a credible signal of high ability, as

workers with a high level of ability tend to find studying easier (less
effort) than people with a low level of ability.
Educational attainment as a
signal of ability
A worker always has the option of
not sending a signal.
• That is, not study for a degree.

Suppose that the disutility of

studying is,
• 50 for a high ability worker.

• 150 for a low ability worker.

In this instance, a university

degree is a credible signal of
high ability, as only a high ability
worker would choose to study.
 The signalling theory of
education
The signalling theory of education states that education can be
valuable to a student, even if the content has no application in the
workplace.
• Attaining a degree is a means by which a student can send a
credible signal of her/his ability.

One implication of the signalling theory of education is that a

degree becomes more valuable as the courses become more
difficult.
• Students of low ability are less likely to attempt courses that
requires a lot of effort.

Note: In reality, a university education both provides you with

knowledge and skills that are valuable in the workplace, and sends
a signal of your ability.
 Quiz 3
Grade c (high) c (low)
A worker's utility is given by
High distinction 80 160 •  
Distinction 60 120
the function
Credit 40 80
The wage for high skilled
Pass 20 40
workers is $90,000, and the
Fail 0 0
wage for a worker without a
signal is $40,000.
 Quiz 3 (2)
Grade c (high) c (low)
High 80 160
What is the lowest grade that
distinction provides a credible signal of
Distinction 60 120 high ability?
Credit 40 80
Pass 20 40 a. High distinction
Fail 0 0
b. Distinction
c. Credit
d. Pass
 Quiz 4
Grade c (high) c (low)
A worker's utility is given by
High distinction 80 160 •  
Distinction 60 120
the function
Credit 40 80
The wage for high skilled
Pass 20 40
workers is $90,000, and the
Fail 0 0
wage for a worker without a
signal is $40,000.
 Quiz 4 (2)
Grade c (high) c (low)
High 80 160
If the difficulty of the course
distinction is lowered, as set out in the
Distinction 60 120 table, what is the lowest
Credit 40 80 grade that provides a
Pass 20 40 credible signal of high
Fail 0 0 ability?
a. High distinction
b. Distinction
c. Credit
d. Pass
 Discussion: Grade inflation
Grade inflation is the phenomenon of individual lecturers, or
universities as a whole, making it easier for students to earn
high grades.
• When grade inflation occurs, a higher proportion of
students receive high grades.
How do you think grade inflation affects a student's
employment prospects?
How do you think that the grading practices at one university
affect the employability of students at another university?
Contracting
 Employing a manager
A firm employs Don to manage a store.
The store's profit is uncertain:
• If business is good, the store will make $1.2M in sales.
• If business is bad, the store will make $0.5M in sales.

The probability that business is good depends on the level of

effort exerted by Don.
• With high effort, business is good with probability pH = 0.5.

• With low effort, business is good with probability pL = 0.2.

Don's welfare

Don's utility function is

•  
• In this equation w is Don's wage, and e is the disutility
Don incurs by exerting effort.
• If Don exerts low effort then e = 0, while if Don exerts
high effort e = 100.
Don's next best alternative to managing the store is a job
that would deliver him 300 units of utility.
• It follows that Don will only accept a contract from the
firm if the (expected) utility is at least 300.
The optimal contract with
observable effort
Suppose that the firm can dictate Don's level of effort. The wage
•
the  firms pays to Don depends on the level of effort it wants Don to
exert.
• If the firm wants low effort then the wage must satisfy
• If the firm wants high effort then the wage must satisfy

The firm's expected profit with low effort is therefore,

E∏= 0.2 x 1,200,000 + 0.8 x 500,000 - 90,000 = $550,000.

This is lower than the firm's expected profit with high effort,

E∏ = 0.5 x 1,200,000 + 0.5 x 500,000 - 160,000 = $690,000.

Exercise: An author's contract
with observable effort

• A publisher commissions Stephen to author a book. If

•  
the book sells well, the publisher will make $6M, while
if sales are bad, the publisher will earn $2M. The
probability of good sales is pH = 0.2 if Stephen exerts
high effort, and pL = 0.1 if he exerts low effort.

• Stephen's utility is described by the function , where e

= 0 if Stephen exerts low effort, and e = 200 if he
exerts high effort. If Stephen does not write the book,
he will receive 500 units of utility from other
endeavours.
 Exercise: An author's contract
with observable effort 2
• Suppose that the effort exerted by Stephen is observable:

1. How much must the publisher pay Stephen to exert low

effort?
2. How much must the publisher pay Stephen to exert high
effort?
3. Which level of effort delivers the publisher the highest
profit (earnings minus the author's wage)?
 Definition: Moral hazard
A phenomenon whereby an individual's actions cannot be
observed and the individual has an incentive to shirk,
exerting less effort than her/his employer would prefer.

In the presence of moral hazard, an employer can create an

incentive for an individual to exert effort by linking the
individual's wage to her/his observed performance.
The participation constraint
Suppose now that the firm cannot observe the level of effort
•  
that Don exerts, but can still observe the sales made by the
store.
An incentive contract pays Don a wage wG if business is
good, and wB if business is bad.

For Don to accept this contract, the expected utility of the

contract when he exerts high effort must be equal to (or
greater than) his second best job offer,
or

This is know as Don's participation constraint because it

describes the condition under which Don will accept the
contract.
The incentive compatibility
constraint
The expected utility of the contract when Don exerts high
•  
effort, must be equal to (or greater than) the expected utility of
the contract when Don exerts low effort,

or,

This is known as the incentive compatibility constraint

because it describes the condition under which Don cannot
improve his welfare by shirking (exerting low effort).
Note: If Don shirks, he does not only incur the disutility of high
effort, but also lowers the probability of earning wG .
The optimal contract with
hidden effort
The optimal values of wG and wB can be found by solving the two
•  
constraints simultaneously.

Substituting for , from the incentive compatibility constraint, into the

participation constraint,

or,

Substituting for into the incentive compatibility constraint,

or
The cost of moral hazard

By utilising an incentive contract the firm is able to

•  
motivate Don to exert a high level of effort, even though it
cannot directly observe Don's actions.
Don's expected wage under the incentive contract is,

higher than $160,000 the firm would pay the manager if it

could observe Don's effort.
The higher cost of the incentive contract is a result of the
need to compensate the risk-averse Don for carrying
some of the risk associated with the store's sales.
Exercise: An author's contract
with hidden effort (1)
•  A publisher commissions Stephen to author a book. If the
book sells well the publisher will make $6M, while if sales
are bad the publisher will earn $2M. The probability of
good sales is pH = 0.2 if Stephen exerts high effort, and pL
= 0.1 if he exerts low effort.

• Stephens utility is described by the function U = , where e

= 0 if Stephen exerts low effort, and e = 200 if he exerts
high effort. If Stephen does not write the book, he will
receive 500 units of utility from other endeavours.
Exercise: An author's contract with
hidden effort (2)

Suppose that the effort exerted by Stephen is hidden:

1. Derive an expression for Stephen's participation
constraint?
2. Derive an expression for Stephen's incentive
compatibility constraint?
3. What is the optimal incentive contract? Does this
contract deliver a higher expected profit than paying
Stephen a fixed wage of $250,000, and having
Stephen exert low effort?
Questions?
 Key concepts from today's
lecture
You can use these concepts (as search terms) to conduct
further research into the topics covered in today's lecture:

• Fair (break-even) price • Signalling theory of

education
• Expected payouts
• Grade in inflation
• Adverse selection
• Moral hazard
• Market unravelling
• Incentive contract
• Universal health care
• Participation constraint
• Signalling
• Incentive compatibility
constraint