Information Economics

 Consider the following variants on the game of

poker:
 The Certainty Game – 5 cards dealt face up so that all
players can see them
 The Imperfect Information Game – 3 cards dealt face up
and 2 face down to each player
 The Imperfect & Asymmetric Information Game – 3
cards dealt face up and 2 cards dealt face down to each
player – each player allowed to look at their own face
down cards
 Information Economics

 In the first game there is little/no incentive to

bet
 In the second game each player is faced with
imperfect but symmetric information. Some
players may be better at judging how the
unseen cards may ‘add value’ to the hand so
there is a little scope for skill and betting
becomes more likely
 Information Economics

 In the third game each player has private

information
 Imperfect & Asymmetric information creates
scope for strategic play
 Bluffing & Misleading signals through the
use of body language & betting behaviour
 Information Economics

 Some transactions in markets &

organizations may feature full information
 Many more feature a degree of asymmetric
& imperfect information
 Hidden information
 Hidden action
 Hidden Information

 Occurs when one party to a transaction has more

information than the other parties about some
exogenous fact relevant to the transaction
 Examples include life insurance and Akerlof’s
market for lemons (2nd hand cars)
 There is an incentive for pre-contract (ex-ante)
opportunism which induces adverse selection
 Hidden Information in Markets

 Originated in insurance markets

 Asymmetric information between the insurer and
the insured
 For medical insurance individuals know more about
their health than the insurer
 Individuals have a better idea of whether insurance
is a ‘good deal’
 Insurers tend to end up insuring ‘bad risks’ –
adverse selection
 Medical Insurance

 Cost of heart by-pass operation is constant at

c
 The size of the population is N
 The number of operations performed per
annum is n
 If everyone was insured:
 Prave=n/N
 Medical Insurance

 If everyone insured the average pay-off

would be:
 Prave=c
 If the insurer set the premium equal to c he
would break even
 This presumes everyone takes out the
insurance
 What if they do not?
 Medical Insurance

 Assume all individuals are risk-neutral and

that individuals have better information
about their health than the insurers
 Pri is the individual’s assessment of the
probability of their making a claim – it is not
known by insurers
 Medical Insurance

 The individuals expected pay-off is:

 Pri x c
 The individual will opt for the medical
insurance iff:
 Pri x c > Prave x c
 Pri > Prave
 Medical Insurance

 Only those with a greater than average risk will

choose to insure
 Under this scenario the insurer makes a loss
 Insurer can raise premium but this forces more
individuals not to insure
 Ultimately premiums are raised to the level where
no-one insures
 This is the adverse selection problem
 Medical Insurance

 In practice individuals have different

attitudes to risk
 Also many do not know precisely their own
level of risk
 Akerlof’s Market for Lemons

 2 second hand cars

 Some information is readily ascertainable by
both sides to any potential transaction (buyer
& seller)
 Some information is asymmetrically
distributed – it is known by the seller but not
by the potential buyer
 Akerlof’s Market for Lemons

 The ‘value’ of a good second-hand car is

£10,000
 The ‘value’ of a lemon is £5,000
 Assume that 50% of cars are good and 50%
are ‘lemons’
 The market price will be £7,500
 Akerlof’s Market for Lemons

 Owners of lemons will be eager to sell their

cars on the open market
 Owners of good cars will not
 Over time this will exert downwards pressure
on price and eventually only lemons will be
supplied
 Trade in good cars will disappear
 Akerlof’s Market for Lemons

 Trade between family & friends

 The importance of guarantees
 Ex-ante monitoring expenditure by the
potential buyer – e.g. A.A. checks
 Reputation of dealers
 Hidden Information in
Organizations
 Consider an employee applying for a job
elsewhere in the same company
 Requires a reference from current ‘boss’ who has
the ‘best’ information
 Reference writer will highly praise bad
employees to get rid of them
 Reference writer will be lukewarm about good
employees to keep them
 Reducing the Impact of Hidden
Information
 Market Segmentation
 Self-selection
 Increase Monitoring
 Forced risk pooling
 Internalization
 Hidden Action (Moral Hazard)

 Having entered into a contract one party is

unable to observe the behaviour of the other
party who may then have an incentive to
engage in post-contract opportunism
 In Markets - Insurance
 In Organizations - Shirking
 Reducing the Impact of Hidden
Action
 Monitoring
 Incentive Pay