Asymmetric Information

Perloff Chapter 19

Asymmetric Information

• When two parties to a transaction have different information.

• Adverse Selection– When an informed person has an advantage through an

unobserved characteristic.– Eg a disproportionately large number of unhealthy

people buy life insurance.• Moral Hazard

– When an informed person has an advantage through an unobserved action.

– An insured car driver drives faster.

Equalising information

• Screening– Obtaining information about hidden characteristics.

– Insurance.

– Costly.

• Signalling– Use of public information to indicate the nature of

private information.

– Restaurant.

Market for lemons and good cars

750

0

Lemons per year

1,000

S L

D L

D*1,500

1,000

(a) Market for Lemons

f

e

Pri

ce o

f a

lem

on

, $

2,000

Good cars per year

1,000

S 2

S1

D G

D*

1,750

1,500

1,250

0

(b) Market for Good Cars

F

E

Pri

ce o

f a

go

od

ca

r, $

Preventing the occurrence of lemon markets

• Laws– Product liability laws,

• Consumer screening– The use of a mechanic,

– Reputation,

• Third party comparisons,– ‘Which’ reports,

• Standards and certification,– Kite marks,

• Signalling by firms– Brand names to

differentiate product.

Price Discrimination Through Asymmetric Information

• Charge a different price according to willingness to pay.

• Some consumer’s may falsely believe a product is of a higher quality.

• Own label product.

Tourist Trap Model

• Pure competitive market:– All firms charge the same price.

– A higher price results in zero demand.

• Imperfect information in a competitive market.– Know the prices charged by shops but not specific price

charged by a specific shop.

– Competitive price is p*.

– Firm can charge p*+e.

– e is less than cost of finding another shop.

Monopoly price in a ‘tourist trap’

• Suppose all firms charge p*+e– Same reasoning implies all firms can raise price to p*+2e

• This argument can continue to be applied until all firms charge the monopoly price.– At this price further price increases result in a loss of profit.

• In a market where finding prices is costly the equilibrium price is the monopoly price.

• If firms are allowed to advertise prices so that search costs disappear the competitive price results.

Employee safety with asymmetric information

• Employees in safer industries pay lower wages than in unsafe.

• Safety statistics are reported at industry levels, not the firm level.

Lying to a potential employer?

Education as a signal

• Low ability people will not graduate.– Have to accept lower unskilled wage.

• High ability people will go to college if difference between skilled and unskilled wage exceeds cost of education

• Two equilibrea are possible– Pooling

• When costs of education exceed the wage differential and everyone is paid the same.

– Seperating• When it pays to go to college.

Pooling and separating equilibrea

Unique or multiple equilibrea

20,000

q, Share of high-ability workers

q = 1 – c————wh – wl

c = wh – wl

10 1–4

1–2

15,000

5,000

Separating equilibrium

Pooling or separating equilibrium

Pooling equilibrium

x

z

y

c, C

ost

pe

r d

iplo

ma

, $