Asymmetric information Flashcards
How can we calculate probability with frequency if we don’t have history of the event?
The number of times that one particular outcome occurred (n) out of the total number of times an event occurred N
What is the expected value and how can we calculate it?
Expected value is the value of each possible outcome times the probability of that outcome summed over all n possible outcomes (weighted sum)
What is variance?
Variance measures the spread of the probability distribution or how much variation there is between the actual value and the expected value
What is the standard deviation?
The square root of the variance and is a more commonly reported measure of risk. (The higher the standard deviation, the higher the associated risk)
When does asymmetric information exist?
When one party to a transaction knows a material fact that the other does not
What is a hidden characteristic?
Attribute of a person or thing known to one party but not others
What is a hidden action?
An act by one party to a transaction known to one party but not to others
What are the two main types of opportunistic behaviour?
- Adverse selection
- Moral hazard
What is adverse selection?
Those with weaker information will engage in harmful market behaviour
What is an example of adverse selection?
The used-car lemon market
If consumers are unable to identify high-quality goods before purchase what will consumers do?
They will pay the same price for all goods (regardless of quality)
Why will the market end up with just lemons?
Unravelling under asymmetric information
What is unravelling under asymmetric information?
If there is a range of car types and the E(v) is lower than the top range, they leave and this continues until there is only lemons
How can information asymmetry be broken?
Signalling and screening
How does competition from the demand side effect the price?
It drives up the price
What is the equilibrium in the labour market?
Combination of wages for each firm and an acceptance decisions for each worker, such that no firm and no worker can make themselves better off by changing their decision
If firms cannot tell worker type, what type of wage to they pay?
The pooling wage rate (expected value of low ability + high ability
What does the pooling wage rate mean for high ability workers?
As it is below their expected wage rate, it incentivises finding a credible signal
What is a two-stage model here?
Stage 1: Firms announce the wage for high and low-education
Stage 2: each worker chooses education then accepts contracts in any
Who is the cost of education higher for?
Low ability workers
If education has no effect on productivity, what is the outcome?
DWL
How do you find the net surplus from acquiring education for high income workers?
Wage - cost of education
What are the key features of separating signalling equilibrium?
- Competing firms make 0 profit
What is the wage rate for low ability workers equal to?
Their marginal value
What is the wage rate for high ability workers equal to?
High-ability workers receive wages higher than the pooling wage, but they also incur additional cost from education
Outline the signalling model?
High ability workers reveal their type by distinguishing themselves from low ability workers through additional effort with no productive value
How is the hard contract set?
The hard task and wage are set such that the low-ability type is just indifferent between the two contracts wh-cL=wL = Wh = 2. The high wage is higher than under pooling, face cost from hard task
How can we verify that we are in an equilibrium?
By checking that no-one has a profitable deviation
How are deviating H-types treated?
As L-types, checking if there is a profitable deviation
What is moral hazard?
The lack of incentive to guard against risk when protected from consequences eg. by insurance
Examples of hidden action?
- Workers on hourly wages
- Bank managers taking more risk when not liable
- Dangerous driving when insured against accidents
What are the different contract types?
- Wage contracts: P(e)
- Pure incentive contracts: P(y)
- Rental contracts: P(y) = y +R
Where is the optimal wage?
When the agent is indifferent between accepting and rejecting
What does it mean if both the principle and the agent are both risk neutral under a pure incentive contract?
Payoffs = expected individual profit
What do pure incentive contracts induce?
Pure incentive contracts induce less effort than first-best and generate lower profit than under observable effort
When the agent is risk neutral, what is the outcome under a rental contract?
When the agent is risk netural then the principal can extract the entire surplus with rental contract independent of whether they can observe effort or not
When are actions are unobservable, what is the relationship between incentives and work?
Incentives and risk work in opposite directions
What is a pooling equilibrium?
A market equilibrium in which both types of goods are traded and
cannot be distinguished by the buyers is a pooling equilibrium.
What is a separating equilibrium?
A market equilibrium in which only one of the two types of goods is
traded, or both are traded and can be distinguished by the buyers, is a
separating equilibrium
