asymmetric information perloff chapter 19. asymmetric information when two parties to a transaction...
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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
, $