Information Asymmetry

Microeconomics: Lecture 9

Shamika Ravi
BITSOM. 2022
Information Asymmetry:
Introduction
 So far – there was perfect information in decision
making for producers and consumers
 What happens when one party knows more than the
other?
 There are market inefficiencies
 Quality game (kulfi game) – markets break down
Three kinds of models in information
asymmetry
1. When sellers know more than buyers
2. When sellers can signal to buyers about quality
3. When buyers have more information than sellers

 All types are trying to explain the underlying

inefficiencies in the market
(1) Market for Lemons
 Quality uncertainty
 When sellers know more than buyers
 Suppose two kinds of used cars are in the market – H,
L
 If both sellers and buyers know which is which – there
will be two markets
 High car market: SH, DH intersection = equilibrium
 Low car market: SL, DL intersection = equilibrium
 But when buyer doesn’t know quality and seller does
 Buyer will view all cars by ‘medium’ quality – DM
 New equilibrium: fewer high quality cars and more low
quality cars will be sold
Market for Lemons
 Consumers realize that more low quality cars are being
sold – their perceived demand DML is lower
 Making mix of cars sold even more worse!
 As a result the perceived demand shifts lower…
 From the high quality sellers point of view – prices are
so low that they don’t want to sell their cars
 Eventually only low quality cars are sold
 OK – so this is an extreme outcome…but the point is…
 The fraction of high quality cars will be lower than it
would be if buyers have more information on quality
Market for Lemons
 That is why brand new cars sell for SO much more
than even mildly used cars
 Why is the second hand cars market vibrant in US –and
not in India?
 Because of information asymmetry, low quality goods
drive out high quality goods
 That is why markets sometime break down
 This phenomenon is called - lemons problem
 Also called: ADVERSE SELECTION
 Thanks to George Akerlof (Nobel Economics 2001)
 Common adverse selection problems
1. Insurance Market:
 Why is it difficult for old people to buy health insurance?
 Adverse selection is a big problem in most insurance
markets – health, accident, auto
 Make it mandatory (Medicare in US, government
intervention)
2. Credit Markets:
 Credit card – credit without collateral
 High risk and low risk customers (those who pay/don’t)
 Same interest rate to all – more risky – higher roi – so on
 Importance of credit history – credit bureaus
(2) Signaling in the Market
 When sellers can ‘signal’ to buyers about quality
 E.g. Labour markets
 Why don’t firms hire – learn quality – fire/keep
labour?
 Too costly!
 Labor Laws very strict in most countries
 Besides, it takes time for labour to become
‘productive’
 So how can potential employees ‘signal’ their
quality?
 Dressing well?
 But even unproductive people can dress well – so it’s
a weak signal!
Signaling in the Market
 A strong signal – something that is easier for high
productivity people to give
 Education – strong signal often used to distinguish
quality
 Education often improves productivity 
 But even if it didn’t – a degree – is a strong signal
 People who are more productive are more likely to
invest in this signal and attain higher education
Job Market Signaling
 Thanks to Michael Spence (Nobel Economics 2001)
 Suppose there are two types of people – H and L
 Marginal product of H is 2
 Marginal product of L is 1
 Hiring firm makes widgets and sells them for Rs. 10
 The population is equally divided between H and L
 The average productivity of all workers is 1.5
 MRPH = Rs. 20; MRPL= Rs.10
 If firms know quality of each employee, then it will
pay them a wage which is equal to their MRP
Job Market Signaling
 But firms don’t know quality so will pay same: Rs. 15
 Low are now earning more at expense of high type
 This is why people want to signal their type/quality
 What will signaling do now?
 Suppose years of education (y) is a single index
representing quality (degree earned, GPA etc.)
 And education costs money – C(y)
 This cost involves tuition, books, hard work,
opportunity cost, etc.
 Critical: cost of education is higher for L than H type
Job Market Signaling
 Low productivity people might find it more difficult to
finish degree etc.
 Suppose education does nothing to productivity – and
is only a signal
 What education level would different people obtain?
 Suppose firm uses a rule – anyone with education of
y* and more is a high type and is offered a bigger
salary
 And anyone with lower education then y* is low type
and is offered a lower salary
 What happens?
 High productivity people will want college degree (y*)
even if it does nothing to increase their productivity
Job Market Signaling

 Education can be an important signal that allows

firms to sort workers by productivity
Job Market Signaling
 Working late into the night?
 Especially true in knowledge based industry – finance,
engineering, law, consulting…
 It takes time for employers to figure out the ‘true’
value of employee, so they rely on signals to make
promotion, salary decisions
 US data: rather than hourly wage, knowledge based
workers are typically paid fixed salary for 35-40
hr/week
 And no overtime wage for additional hours
 ..yet, 27% of knowledge based workers puts in 60-70
hrs/week (2010)
 Quality Signaling: Guarantee and
Warranties
Remember the kulfi game?
 Market for durable goods, electronics – some brands
are more dependable than others
 If consumers can’t tell difference – there would be no
price variation
 Firms that produce high quality product signal to
consumers through guarantees and warranties
 Because an extensive warranty is more costly for low
quality products – such firms will not provide this
 Consumers can then correctly view warranties as a
signal for quality and be willing to pay more
 (3) Moral Hazard
 When actions are unobserved – people can’t be monitored – they
might become careless and raise costs
 Insurance market
 Job Shirking
 Sub prime crisis – bail out of banks
 Farm loan waivers

 Example: Fire insurance

 Without insurance – you will invest in some safety devices to
keep probability of fire low
 With insurance – you might not make this investment – therefore
raising probability of fire and cost of insurance!
 Moral Hazard
 The economic inefficiencies due to moral hazard
 The social cost of doing something is reduced because
now you have insurance
 So you tend to overuse facilities

 Solutions to mitigate moral hazard in insurance

business:
 Co-payments
 Deductibles