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Asymmetric Information-Introduction

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Asymmetric Information-Introduction

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varshneyanaisha
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Introduction to Asymmetric

Information

By
Dr. Siddharth Singh
Assistant Professor
Department of Economics

Dr. Siddharth Singh, Department of Economics


Asymmetric Information
• In purely competitive markets all agents are
fully informed about traded commodities and
other aspects of the market.
• Markets with one side or the other
imperfectly informed are markets with
imperfect information.
• Imperfectly informed markets with one side
better informed than the other are markets
with Asymmetric Information.

Dr. Siddharth Singh, Department of Economics


• Hidden actions are actions taken by one
side of an economic relationship (agent)
that the other side of the relationship
(principal) cannot observe.
• Agent: a person who is performing an act
for another person, called the Principal.
• Hidden characteristics are things that one
side of a transaction knows about itself
that the other side would like to know but
does not.
Dr. Siddharth Singh, Department of Economics
Asymmetric Information: Examples

• A worker knows more than his employer about how


much effort he puts into his job. (example of a hidden
action)
• A seller of a used car knows more than the buyer
about the car’s condition. (example of a hidden
characteristic).
• A customer knows her taste for a good or a service
better than the firm that supplies and prices it.
(example of a hidden characteristic).
• A person knows more about his driving habits than
the company that provides his auto insurance
(example of a hidden characteristic)

Dr. Siddharth Singh, Department of Economics


Moral Hazard
• Problems after a contract is written.
• The tendency of an imperfectly monitored agent to
engage in dishonest or otherwise undesirable
behavior.

Adverse Selection
• Problems before a contract is written.
• Refers to the tendency for the mix of unobserved
attributes to become undesirable from the
standpoint of an uniformed party.
• Imperfect information influences resource allocation
and the price system.
Dr. Siddharth Singh, Department of Economics
Moral Hazard: Example
• Classic example: employment. The employer is the
principal and the worker is the agent. Moral Hazard
is the temptation of imperfectly monitored workers
to shirk their responsibilities.

• Employer’s possible responses to Moral Hazard:


Better monitoring.
• Delayed payment – the employer can delay part of
worker’s compensation so that, if caught shirking
and fired, the worker incurs a higher loss.
Dr. Siddharth Singh, Department of Economics
Adverse Selection: Example
• Market for used cars. The lack of complete information
when purchasing a used car increases the risk of the
purchase and lowers the value of the car.
• Automobile Insurance: A firm selling car insurances
cannot identify owners living in high crime areas. If
average cost is charged, it can lead to insurance firm
losing out.

• The Market for Credit: Asymmetric information creates


the potential that only high risk borrowers will seek loans.
How can credit histories help make this market more
efficient and reduce the cost of credit?

Dr. Siddharth Singh, Department of Economics


• Medical Insurance: Buyers of health
insurance know more about their health
problems than do insurance companies.
Because people with greater hidden health
problems are more likely to buy health
insurance than are other people, the price of
health insurance reflects the cost of a sicker-
than-average person.

• Is it possible for insurance companies to


separate high and low risk policy holders? If
not, only high risk people will purchase
insurance. Adverse selection would make
medical insurance unprofitable.
Dr. Siddharth Singh, Department of Economics
• When markets suffer from adverse selection,
there are some problems:

• Owners of good cars may choose to keep


them rather than sell them at the low price
that skeptical buyers are willing to pay.
• In insurance markets, buyers with low risk
may choose to remain uninsured, because the
policies they are offered are too expensive,
given their true characteristics.

Dr. Siddharth Singh, Department of Economics


• In American slang, a lemon is a car that is found to be
defective after it has been bought. Suppose buyers cannot
distinguish between a high-quality car (a "peach") and a
"lemon". Then they are only willing to pay a fixed price for
a car that averages the value of a "peach" and "lemon"
together

• Sellers of cars know their vehicles’ defects while buyers


often do not. Because owners of the worst cars are more
likely to sell them than are the owners of the best cars,
buyers fear they would get a “lemon”.

• Low quality goods drive high quality goods out of the


market.
• The market has failed to produce mutually beneficial trade.
• Adverse selection occurs; the only cars on the market will
be low quality cars.
Dr. Siddharth Singh, Department of Economics
• Two types of cars: “lemons” and “peaches”.
• Each lemon seller will accept $1,000; a buyer
will pay at most $1,200.
• Each peach seller will accept $2,000; a buyer
will pay at most $2,400.
• If every buyer can tell a peach from a lemon,
then lemons sell for between $1,000 and
$1,200, and peaches sell for between $2,000
and $2,400.
• Gains-to-trade are generated when buyers
are well informed.
Dr. Siddharth Singh, Department of Economics
• Suppose no buyer can tell a peach from a
lemon before buying. What is the most a
buyer will pay for any car?
• Let α be the fraction of peaches.
• (1-α) is the fraction of lemons.
• Suppose Expected Value (EV) > $2000. (for
the buyer)
• Every seller can negotiate a price between
$2000 and $EV (no matter if the car is a
lemon or a peach).
• All sellers gain from being in the market.
Dr. Siddharth Singh, Department of Economics
• Suppose EV < $2000.
• A “peach” seller cannot negotiate a price below
$2000 and will exit the market.
• So all buyers know that remaining sellers own
lemons only.
• Buyers will pay at most $1200 and only lemons
are sold.
• Hence “too many” lemons “crowd out” the
peaches from the market.
• Gains-to-trade are reduced since no peaches are
traded.
• The presence of the lemons inflicts an external
cost on buyers and peach owners.
Dr. Siddharth Singh, Department of Economics
• A market equilibrium in which both types of
cars are traded and cannot be distinguished
by the buyers is a pooling equilibrium.
• A market equilibrium in which only one of the
two types of cars is traded, or both are traded
but can be distinguished by the buyers, is a
separating equilibrium.

Dr. Siddharth Singh, Department of Economics


• Market Signaling: A Problem of Asymmetric Information
• In the markets for used cars, the owners know the quality, but the purchasers
have to guess the quality. This asymmetric information can cause problems in the
market for used cars. In some cases the adverse selection problem could result in
too few transactions taking place. But this is not the whole truth.

• The owners of the good used cars have an incentive to try to convey the fact that
they have a good car to the potential buyers. They would be eager to take actions
which signal the quality of their car to those who might buy it.

• One possible and at times sensible signal would be for the owner of a good used
car to offer a warranty. This is the promise to pay the purchaser some stipulated
sum of money it the car did not meet the original specifications (i.e., if it turns
out to be a bad car). The owners of the good used cars can afford to offer such a
warranty while the owners of bad cars cannot afford this. This is one way for the
owners of the good used cars to signal that they have good cars.
Dr. Siddharth Singh, Department of
Economics
• Spence’s Labour Market Signalling Model

• The analysis of screening processes was put forward by Michael Spence in his
article “Job Market Signaling”, 1973.

• An important mechanism through which sellers and buyers deal with the problem
of asymmetric information is market signaling. In some markets, sellers send
buyers signals that convey information about the quality of a product. The term
was first coined by the Nobel laureate economist Michael Spence in 1974.

• In the labour market, workers (the seller of labour) know much more about the
quality of the labour than the firm (the buyer of labour). It is not possible for the
firm to know the productive potential of employers before hiring them.

• High-productivity people command higher wages by giving a signal which low


productivity people cannot give. Education may be a useful signal of high
productivity of a group of workers.
Dr. Siddharth Singh, Department of
Economics
• Education can directly and indirectly improve a person’s productivity by
providing information, skills, and general knowledge that are helpful in work.
But even if education does not improve productivity, it can still be a useful signal
of productivity because a high-productivity group finds it easier to attain higher
levels of education.

• In fact, as a general rule, productive people tend to be more intelligent, more


motivated, more disciplined and more energetic and hard-working. More
productive people are, therefore, more likely to attain high levels of education in
order to signal their productivity to the firms for getting highly-paid jobs. Thus
firms are correct in considering education as a signal of productivity.

Dr. Siddharth Singh, Department of


Economics
Thank You

Dr. Siddharth Singh, Department of Economics

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