• Chapter 38 Asymmetric Information

• Key Concept: adverse selection and

moral hazard.

• Incentives, incentives, incentives!

• Chapter 38 Asymmetric Information

• So far we assume buyers and sellers are

both perfectly informed about the quality
of goods being sold in the market.

• In reality, it is often the case that one of

the transacting party has less information
than the other.
• One example is the labor market. It may
be difficult for a firm to determine how
productive its employees are.

• When a consumer buys a used car, it may

be hard to determine whether it is a good
car or a lemon. By contrast, the seller
may has a pretty good idea.

• This asymmetric information may cause

significant problems with the efficient
functioning of a market.
• Consider a market with 100 people who
want to sell their used cars and 100
people who want to buy a used car.

• Everyone knows that 50 cars are lemons

and 50 are plums.

• The current owner knows the quality of

his car, but the potential purchasers do
not.
• The owner of a lemon is happy to part
with his car for 1000 and that of a plum
for 2000.

• The buyers are willing to pay 1200 for a

lemon and 2400 for a plum.

• If information is symmetric, then the

lemon will sell at some price between
1000 and 1200 while the plum between
2000 and 2400.
• What if the information is not symmetric?

• Since there are 50 lemons and 50 plums,

buyers are willing to pay up to
0.5x1200+ 0.5x2400=1800.
• Yet at 1800, only the owners of lemons
are willing to sell their cars.

• However, in equilibrium, buyers cannot

have wrong expectation, so they expect to
see only lemons in the market.

• When this happens, buyers are willing to

pay only 1200.
• Thus only lemons get sold while none of
the plums do.

• This differs from the case when

information is symmetric.

• None of the plums ever get sold. Even

though the willingness to pay is higher
than the willingness to sell. No
transactions will take place.
• This is an example of adverse selection.
There are some other examples like
insurance, car insurance, health
insurance, so market equilibrium is
typically not efficient.
• If insurance companies base their rates on
the average incidence of health problems,
people who want to purchase it the most
are the ones who are likely to need it the
most.

• Thus, the rates must reflect this disparity.

• Marriage market?
• Adverse selection arises when an
informed individual’s trading decisions
depend on his privately held information
in a manner that adversely affects
uninformed market participants (hidden
information).
• In the used-care market, an individual is
more likely to decide to sell his car when
he knows it is a lemon.

• When adverse selection is present,

uninformed traders will be wary of any
informed trader who wishes to trade with
them, and their willingness to pay will be
low.
• This fact may even exacerbate the
adverse selection problem.

• If the price that can be received by selling

a used car is very low, only sellers with
really bad cars will offer them to sell.
• There are ways evolved to alleviate this
inefficiency.

• For instance, compulsory purchase plan,

employee insurance as fringe benefits.
• The high-risk people are better off
because they can purchase insurance at
rates that are lower than the actual risk
they face and the low risk people can
purchase insurance that is more favorable
to them than the insurance offered if only
high–risk people purchased it.
• Talk a bit about reputation and
standardization.
• Some practices also emerge.

• For instance, the owner of a plum can

offer a warranty, a promise to pay the
purchaser some agreed upon amount if
the car turned out to break down.

• Or he can allow the purchaser to take his

car to a technician to examine his car.
Now these are called signaling.
• Let us look at a prototype example.

• Suppose we have two types of workers,

able and unable.

• Able workers have MPL of a2 while

unable a1 and a2>a1.
• The fraction of able workers is b. The
faction of unable workers is 1-b.

• If firms can distinguish two types of

workers, then they will offer wage a2 to
able and to a1 unable.
• However, if they cannot, they can only
offer ba2+(1-b)a1.

• Now if under this wage, both types will

work, then there is no problem of
efficiency loss even information is
asymmetric.
• Suppose now workers can acquire
education to signal his type.

• Now workers acquire education first and

then firms decide how much to pay after
observing the choice of education by
workers.

• Assume the education does not affect the

productivity at all to simplify.
• Let e2 be the education acquired by able
and e1 by unable.

• Let c2e2 be the cost for able and c1e1 for

unable.

• Suppose further that c2<c1.

• Let e* satisfy (a2-a1)/c1 < e*< (a2-a1)/c2.

• Then we have an equilibrium where able

workers get education e* and unable 0.

• Firms pay a2 when they see e*and pay a1

when they see 0.
• Let e* satisfy (a2-a1)/c1 < e*< (a2-a1)/c2.

• Does anyone have an incentive to deviate?

• Would unable mimic able? If he did, then

the gain is a2-a1 while the cost is c1 e*.

• The first inequality guarantees that this is

not profitable.
• Let e* satisfy (a2-a1)/c1 < e*< (a2-a1)/c2.

• What about able workers? Would he

deviate to acquire education of 0?

• If he did, the loss is a2-a1 while the gain

(saved cost) is c2e*. The second
inequality guarantees that loss is bigger
than gain and so it is not profitable to do
so.
• Hence it is indeed an equilibrium.

• In this equilibrium, able and unable

workers separate.

• This is called a separating equilibrium

where two types choose different signals
to separate.
• However, in this setup it is a pure waste
to signal.

• Able workers find it in their interest to

pay for acquiring the signal, even though
it does not change his productivity.
• This is because we start from a situation
where the market is efficient.

• When the competitive equilibrium is not

efficient, though signaling has cost, it
might have some benefit and may
improve efficiency.

• Signaling can make things better or

worse. Each case has to be examined on
its own merits.
• Is education simply a signal?

• There seems to be a discontinuous jump

in wage. Earnings of high school
graduates are much higher than the
incomes of people who have only
completed 3 years of high school.
• This sheepskin effect, in reference to the
fact that diplomas were often written on
sheepskins, suggests graduation from
high school is some kind of singal.

• But what does it signal?

• Data seems to suggest high school
graduates had significantly lower quit and
absentee rates than nongraduates.
• Another interesting problem arising in the
insurance market is known as the moral
hazard.

• This relates to the phenomenon that after

contracting (insured), one transacting
party may have the incentive to take less
care (hidden action).
• If no theft insurance is available, car
owners may buy expensive locks.

• On the other hand, after purchasing the

theft insurance, care owners may not buy
expensive locks.
• Moral hazard could manifest in unusual
forms.

• Mountain climbers with better gear may

take more challenges. This may expose
them to greater risks. This is also a form
of moral hazard.
• When an insurance company sets its
rates, it has to take into account the
incentive change.
• The tradeoffs involved are:

• too little insurance means people bear too

much risk

• too much insurance means people will

take inadequate care

• So the whole point is on balancing these

two.
• Hence an insurance policy often includes
a deductible, the amount that the insured
party has to pay in any claim. (compared
this with premium).

• This is designed to make sure that

consumers will take some care.
• Now the whole problem becomes how
can I get someone do something for me?

• This naturally leads us to the incentives

problems.
• Suppose we have a worker (agent) who if
exerting effort x can produce output
y=f(x).

• Efforts are not observable but outputs are.

• effort x, output y=f(x).

• Efforts are not observable but outputs are.

• Let the cost of x be c(x) and the worker

has some outside opportunity which gives
him the utility of u.
• effort x, output y=f(x).

• Then the whole problem boils down to

choosing the payment s(y)=s(f(x)) to the
worker to max the profit of the Principal.
• Now to make the worker participate, we
have the participation constraint or the
individual rationality IR constraint.

• That is, s(f(x))-c(x)u.

• If we can observe x, the principal simply
maxx f(x)-s(f(x))
subject to s(f(x))-c(x)u.

• This can be solved by maxx f(x)-c(x)-u

(**).

• So FOC is MP(x*)=MC(x*).
• But if x is not observable, then we need
to worry about whether agents will
indeed choose x*.
• This brings us to another constraint,
called the incentive compatibility IC
constraint.

• It means that s(f(x*))-c(x*) s(f(x))-c(x)

for all x.
• There is a way to do this, that is, to sell
the firm to the agents.

• So s(f(x))=f(x)-R.

• If the worker max s(f(x))-c(x)=f(x)-c(x)-

R, then it looks just like (**).

• So x* will be chosen if IR is OK.

• To make IR OK, we just choose R so that
f(x*)-c(x*)-R=u.
• In short, the sell-out contract is to make
the agents the residual claimant so that he
will take the proper care.
• However, this is good because we assume
risk neutrality of agents.

• If agents are risk averse, then this

incentive scheme may entail too much risk
on agents and for this reason, we do not
see that every principal uses this kind of
scheme to motivate his agents.
• So sometimes we see sharecropping such
as s(f(x))=af(x)+F.

• The incentives to the agent are not exactly

right. But this is something of a happy
medium. The worker and the employer
share the risk of output fluctuations. It also
gives the worker an incentive to produce
output but it does not leave him bearing all
the risk.
• A note on the voting right of a
corporation.

• It is often the case that shareholders have

the right to vote on various issues while
bond holders do not.
• Why is that? The answer may lie in the
incentives.

• If a corporation produces X dollars and

total claim is B dollars of bond holders.

• Then the amount that goes to

shareholders is X-B. So this makes sure
the shareholders have the right incentives
to max X.
• At 1978, the Chinese central government
instituted a responsibility system that any
production in excess of a fixed quota was
kept by the household and could be sold
on private markets.

• This makes the household the residual

claimants.
• Between 1978-1984, the output of
agriculture increased by 61%.

• It is estimated that over ¾ of the increase

was due to the improvement in
incentives.
• The Grameen Bank

• Villagers have better information about

other’s credibility.

• They could also monitor or help each

others better.
• Chapter 38 Asymmetric Information

• Key Concept: adverse selection and

moral hazard.

• Incentives, incentives, incentives!