Competitive Markets Under
Asymmetric Information
Chapter 11
An assumption of pure competition was complete
knowledge of all market information. But
knowledge can be unevenly distributed among firms
and consumers.
The concept of a "lemon" in the car market and
adverse selection problem are only two of the
interesting market phenomena when information is
unevenly distributed (asymmetric) among the market
participants
2002 South-Western Publishing
Slide 1
Asymmetric Information
• Used car: who knows what about it?
• Incomplete Information -- uncertain
knowledge of payoffs, choices, or types of
opponents a market player faces.
• Asymmetric Information -- unequal or
dissimilar knowledge among market
participants.
Slide 2
不完全訊息與訊息不對稱
• 不完全訊息
» 當某些訊息不知道的時候（不確定性）
• 不對稱訊息
» 一方比另一方擁有更多、更優越的訊息
• 擁有較少、較劣質訊息的一方遭遇不完全訊息
• 不完全訊息的的例子
» 明天的天氣
» 明天的道瓊指數和恒生指數
Slide 3
不完全訊息與訊息不對稱（續）
• 所有人對將來都不確定：沒有不對稱
• 對比
» 汽車保險
• 司機對於自己的小心程度和習慣比保險公司有更
清楚的瞭解：訊息不對稱
• 保險公司對於司機的小心程度和習慣有不完全訊
息
Slide 4
Incomplete Contracting and
Incomplete Markets
• Insurance works when we can pool a group of
possible events (like injuries at work) to reduce the
risk of loss to any one party.
• But some risks are catastrophic, like a nuclear
accident. It is difficult to assess the likelihood or the
damage; hence, insurance in this case is often
unavailable.
• Contracts can specify duties under several states of
the world, but sometimes the outcomes are too
numerous or unknowable for years. This creates
incomplete contracts.
Slide 5
Types
• Full contingent claims contract -- specifies all
possible future events.
• Incomplete contingent claims contract -- not
all possible future events are specified.
• Due to incomplete contracts, some people may
take advantage of spirit of the contract.
» Accident insurance may permit people to succumb
to a moral hazard by acting recklessly.
Slide 6
Asymmetric Information
in a Lemon's Market
• Search goods are products or services whose quality is
best detected through a market search.
• Experience goods are products and services whose
quality is undetected when purchased.
• To protect consumers, warranties and firm reputations are
used to assure quality.
• But if someone is selling his or her car, isn't it likely that
the car is no good: a lemon?
• If one firm defrauds customers, how do the reputable
firms signal that they are NOT like the fraudulent
firm?
Slide 7
Adverse Selection and the
Notorious Firm
• Game: A firm may decide to produce a
High Quality or Low Quality product, and
the buyer may decide to offer a High Price
or a Low Price.
• Since the firm fears that if it offers a High Quality
product but that buyers only offer a Low Price,
they only produce Low Quality products and
receive Low Prices.
• This is the problem of adverse selection
Slide 8
Notorious Firm Game Analysis
BUYER
• Simultaneous
decisions
Hi Price
Low Price
High
Quality
• A risk averse decision
130
70
by the firm is to make a SELLER
Low Quality product
Low
150
90
Quality
• Best for the buyer is a
low price, but a high
quality good. Worst is a
Payoffs are for
High price but a Low
the Seller only
quality good.
Slide 9
Solutions to the Problem of
Adverse Selection
• Regulation (Disclosure Laws, Truth in Lending)
• Long term relationships, or reliance
relationships
• Brand names (a form of a “hostage” to quality)
• Nonredeployable assets are assets that have
little value in another other use
» Example: Dixie Cups made with paper-cup machinery
which cannot be used for other purposes — if Dixie Cups
leak, the company is in trouble
Slide 10
Cost Revelation in
Joint Ventures and Partnerships
• Potential partners have different information
when beginning a venture together
• The Clarke tax mechanism
» The mechanism is to assign probabilities to the
revelation of costs of the partner.
» After the other partner's expected costs are covered,
they receive the residual or net profit.
» Then each has an incentive to reveal their true cost.
Slide 11
Optimal Incentives Contract
• is an agreement about the payoffs and
penalties that creates appropriate incentives
• If the contract creates a stream of profits,
then a breach is a costly penalty
example: an employee who steals is fired! If
the employee felt the employment at that
firm was rewarding, the penalty of firing is
severe.
Slide 12
Principal-Agent Problem
in Managerial Labor Markets
• Stockholders (principals) hire managers
(agents) with different incentives.
• Alternative labor contracts
» Pay based on profits
» Paying a bonus on top of a salary when goals are
exceeded
» Have manager own stock
• Benchmarking involves a comparison of similar
firms, plants, or divisions
Slide 13
Signaling and Sorting of
Managerial Talent
• Applicants to positions know more about
themselves than they reveal, which is the
problem of asymmetric information.
• For example, is the applicant highly risk
averse or a risk taker?
• How can we sort between risk-takers and
risk averse candidates?
Slide 14
One Sorting Method
• A Linear Incentive Contract provides a combination of
salary and (plus or minus!) a profit sharing rate.
• An offer that dominates all other offers will not help
distinguish among applicants. This is a pooling
equilibrium.
• Offers that distinguishes between behaviors is a separating
equilibrium.
• For example, a risk averse person would tend to
select an offer which primarily paid a base salary
• Whereas the risk-loving individual would tend to
select an offer with more profit sharing.
Slide 15
Sorting Managers with Incentives
Base Rate
Salary
B
A
Figure 11.4
• Contract A has lower
profit sharing rate and
lower base rate than
Indifference
Contract B
curve for risk
the risk lover
• Both the risk averse
and the risk lover
picks contract B
over contract A
• A pooling equilibrium
Indifference
curve for risk
averse person
Profit Sharing Rate
in  percentages
Profit Sharing points of equal
profit to the firm
Slide 16
Sorting Managers with Incentives
• Contract A has a
lower profit sharing
Base Rate
Salary
rate and a lower base
Indifference
curve for risk rate than Contract C
B
the risk lover
• However, the risk
lover prefers C to A
• The risk averse person
A C
prefers A to C
• A separating
equilibrium is
offering A or C.
Profit Sharing Rate
Indifference
curve for risk
averse person
Figure 11.4
in  percentages
Slide 17