12. Asymmetric Information Flashcards
Asymmetric Information in Markets
In purely competitive markets all agents are fully informed about traded commodities and other aspects of the market. Imperfectly informed markets with one side better informed than the other are markets with asymmetric information.
Examples:
- A doctor knows more about medical services than does the buyer.
- An insurance buyer knows more about his riskiness than does the seller.
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In what ways can asymmetric information affect the functioning of a market?
2 problems (2 type of remedies):
- Adverse selection
- Moral hazard
- Signaling [remedy]
- Incentives [remedy]
Adverse Selection (Akerlof 1970, QJE)
- Consider a used car market: 100 people want to sell their used car; 100 people want to buy.
- Two types of cars; “lemons” and “plums”. - Everyone knows that 50 of the cars are plums, 50 are lemons.
- Each lemon seller will accept $1,000; a buyer will pay at most $1,200.
- Each plum seller will accept $2,000; a buyer will pay at most $2,400.
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Suppose quality of the cars can be verified.
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If every buyer can tell a plum from a lemon, then lemons sell for between $1,000 and $1,200, and plums sell for between $2,000 and $2,400.
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N.B. Gains-to-trade are generated when buyers are well informed.
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Suppose that now quality can not be verified: no buyer can tell a plum from a lemon before buying.
What is the most a buyer will pay for any car?
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Varian, p. 741: “…..The buyers have to guess about how much each car is worth. We’ll make a simple assumption about the form that this guess takes: we assume that if a car is equally likely to be a plum as a lemon, then a typical buyer would be willing to pay the expected value of the car. Using the numbers described above this means that the buyer would be willing to pay”:
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EV: (1/2)* 1200 + (1/2)* 2400 = $1800.
Assumption of neutrality to risk: WTP = EV (if risk-aversion WTP < EV)
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EV = ProblemonsWTPlemons+ ProbplumsWTPplums
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But who would be willing to sell their car at that price?
The owners of the lemons certainly would
The owners of the plums certainly not: they need at least $2000 to part with their cars.
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N.B. At a price of $1800 only lemons would be offered for sale
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Adverse Selection: Conclusions - No plums are sold
- Consumers soon realize that only lemons are sold
- They revise their expectations (lemons prob. = 1; plums prob. = 0)
- Lemons are the only cars sold: the equilibrium price will be somewhere in-between $1000 and $1200.
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Even though the price at which buyers are willing to buy plums exceeds the price at which sellers are willing to sell them, no such transactions will take place.
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In the used car market, producers do not choose endogenously whether to have “plums” or “lemons”.But note that adverse selection may also occur when producers do have the option to produce low-quality or high-quality goods and face different costs for producing the two (see the Appendix taken from Varian)
Asymmetric information
- Adverse selection is a problem of hidden information
. - But we have a second problem originated by asymmetric information: moral hazard. This is caused by an hidden action problem
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Extra:
1) Adverse selection: it is a problem of hidden information. In a market, there can be good or bad products. The problem is that there is an externality between the sellers of good products and bad products; when an individual decides to try to sell a bad product, it affects the purchaser’s perceptions of the quality of the average product on the market. This lowers the price that they are willing to pay for the average product and thus hurts the people who are trying to sell good products. This type of externality leads to a market failure. For example, in the market of innovation finance, there are good or bad innovation projects. Banks or other providers of finance for the project do not know the quality of the project. Due to this risk, in the equilibrium, banks pose unfavorable conditions for lending, such as high interest rates. The capable innovators may prefer to give up searching for external debt finance (discouraged borrowers) or search for other financing sources.
Moral Hazard
Moral hazard in a transaction occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.
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Let’s focus on the insurance Mkt:
If one has full bike insurance what are the probabilities that he will leave the bike unlocked?
1) Suppose no insurance is available
Consumers have an incentive to take the maximum possible amount of care (large expensive locks, avoiding go in high-risk areas, etc.)
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2) Suppose a full insurance is available
Consumers have no incentive to take any care. In case of theft, they can get money from the insurance company and buy a brand new bike. This lack of incentive to take care is what is called MORAL HAZARD.
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NOTES:
1) Moral hazard is a hidden action problem: if the amount of care is observable, there would be no problem.
2) The insurance company faces a trade-off: full insurance (higher immediate returns) means too little care will be undertaken by ensured (higher risk of bearing great costs later).
3) Where is the market inefficiency here?
The possibility that moral hazard might occur can lead to less trade than the optimum
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Consumers may want to buy more insurance, and the insurance companies would be willing to provide more insurance if the consumers continued to take the same amount of care . . . but this trade won’t occur because if the consumers were able to purchase more insurance they would rationally choose to take less care!
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Extra:
2) Moral hazard: in a transaction, it occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information. Moral hazard is a problem of hidden actions: if the actions of the party with more information were observable, there would be no problem. It is a market failure because the moral hazard leads to less trade than the optimum. Following the previous example, a bank cannot control strategies and choices of the innovators. Therefore, the innovators may put in place actions not in the interest of investors. The solution can be the imposition of milestones to control how the project is going on, or a co-investment in order to guarantee the high effort of the innovators.
Asymmetric Information: remedies: Signaling
In the example of the used cars market:
Plums sellers may use warranties.
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A warranty (of let’s say 1,500$) if the car breaks down can be convenient only for plum sellers (good cars do not break down very often), while it could not be replicable by lemons sellers pretending to be sellers of good cars (their lemons break down very often).
-> The “good” is now distinguishable from the “bad”.
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Adverse selection is an outcome of an informational deficiency. What if information can be improved by high-quality sellers signaling credibly that they are high-quality?
E.g. warranties, professional credentials, references from previous clients, etc.
Signaling (Spence, 1974, “Job Market Signaling”, QJE)
A labor market has two types of workers: high-ability and low-ability.
A high-ability worker’s marginal product is aH.
A low-ability worker’s marginal product is aL.
aL < aH.
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A fraction h of all workers are high-ability.
1 - h is the fraction of low-ability workers.
Each worker is paid his expected marginal product.
If firms knew each worker’s type they would:
- pay each high-ability worker wH = aH
- pay each low-ability worker wL = aL.
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If firms cannot tell workers’ types then every worker is paid the (pooling) wage rate; i.e. the expected marginal product:
wP = (1 - h)aL + haH.
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As long as the good and the bad workers both agree to work at this wage (and high ability workers maintain their high level of productivity) there is no problem with adverse selection in the eyes of the firm.
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But suppose the firm fears that the pooling wage scheme may depress high-ability workers and be detrimental to its profit and therefore it is very much willing to look for a separating equilibrium: wH = aH and wL = aL
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Signaling: 2 questions
- How can this separating equilibrium be achievable? If wH and wL is the wage scheme offered, how is possible to select the “right” types of workers for the “right” wage?
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- How is it possible for high-ability workers being selected for wH and not wL? How can they credibly demonstrate their nature?
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SIGNAL: a costly method available to signal you are a good type such that the cost of signaling is too high for bad types that they won’t do it
- Michael Spence, Market Signaling (Cambridge, Mass: Harvard University Press,1974)
Besides being costly, of course signals should be observable (Connelly et al. 2011, JoM, vol. 37, 39-67).
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Workers can acquire “education”.
Education costs a high-ability worker cH per unit and costs a low-ability worker cL per unit.
cL > cH.
Suppose that education has no effect on workers’ productivities (extreme assumption, just to make the point and make it simple, obviously this should not be necessarily true in real life): i.e., the cost of education is a deadweight loss.
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High-ability workers will acquire eH education units if(i) wH - wL = aH - aL > cHeH, and(ii) wH - wL = aH - aL < cLeH.
(i) says acquiring eH units of education benefits high-ability workers.
(ii) says acquiring eH education units hurts low-ability workers.
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aH-aL/cL < eH < aH-aL/cH
Acquiring such an education level credibly signals high-ability, allowing high-ability workers to separate themselves from low-ability workers.
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P.S.: how much education should low-ability workers acquire (in this very simplified framework)? Zero. Given that acquiring eH units is not convenient for them, they will be paid wL = aL in any case, even if they acquire a lower level of education (say eL).
Signaling: Note
Signaling can improve information in the market. But it involves a cost, and for this reason, the equilibrium is sub-optimal with respect to a full information scenario.
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If the pooling equilibrium is accepted by high-ability workers (and does not affect their high productivity) total output does not change. Education is costly so signaling may hurt market’s efficiency: to some extent resources are wasted in order to enforce a separating equilibrium.
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What’s the role of Government in signaling?Limited but with one notable exception
Asymmetric Information
- Search goods (no Asymmetric Info)
Experience goods (Asymmetric Info only ex-ante)
+ Credence goods (Asymmetric Info ex-ante but also ex-post) [Limited but with one notable exception]
Asymmetric Information: remedies: Incentives
In the example of the full bike insurance
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The insurance companies generally never offer the consumers “complete” insurance. They will always want the consumer to face some part of the risk. This is why they usually include a “deductible,” an amount that the insured party has to pay in any claim. By making the consumers pay part of a claim, the insurance companies can make sure that the consumer always has an incentive to take some amount of care.
-> The buyer is incentivized
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Incentives -> Hidden action (moral hazard) -> Principal-agent theory
Principal-agent theory (Agency theory)
Area of economics that deals with all situations where there is a principal who wants an agent to act in the principal’s interest to achieve some goal.
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When the principal possesses less information than the agent, the two have different objective functions, principal can not monitor perfectly agent’s behavior and resulting performance of agent’s action is noisy. -> Principal-agent problem
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In such situations, the agent can indulge in moral hazard, but proper incentives set by the principal, by re-aligning objective functions between the two, can help mitigate the problem
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See diagram for eg
Flexible remuneration schemes
How the principal can mitigate the problem?
Choosing another form of remuneration, making the “agent” participate to the sharing of the performance (i.e. part of the agent’s salary depends on the final performance)
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Sharecropping in agriculture
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Stock options for managers in public companies
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Many corporations are owned by a large number of small shareholders. This considerably decreases the incentives for each single shareholder to monitor the behavior of managers: the effort necessary is very high compared to the benefit. Board of directors only partly defend shareholders, and managers are better informed anyway.
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See diagram eg
References
Varian (Intermediate Microeconomics, chapter 38).
Extra
Adverse selection is an outcome of an informational deficiency. High-quality sellers can improve information through signals of high quality, such as warranties, references from previous customers and professional credentials. Companies sustain the cost of signaling in order to improve information, for example patents for innovative companies. Signaling allows to reach a pooling equilibrium, which means the total output of the company does not change but resources are wasted in order to signal. For example, if a company has to distinguish between good workers and bad workers, a signaling mechanism is the education. Assuming that education does not change the output produced by bad/good workers, it is a pooling equilibrium because the firm wasted resources in education in order to signal without being able to separate bad and good workers. It means that the firm is not able to reach a separating equilibrium. It hurts the market efficiency. An alternative solution is to put incentives, which allow the company to go from a pooling equilibrium to a separating equilibrium. The incentives have the purpose to make the workers’ type reveal itself.
