Chapter 17
Markets with Asymmetric
Information
Introduction
 We can see what happens when some
parties know more than others –
asymmetric information
 Frequently a seller or producer knows
more about he quality of the product than
the buyer does
 Managers know more about costs,
competitive position and investment
opportunities than firm owners
©2005 Pearson Education, Inc.
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Quality Uncertainty and the
Market for Lemons
 Asymmetric information is a situation in
which a buyer and a seller possess
different information about a transaction
The lack of complete information when
purchasing a used car increases the risk of
the purchase and lowers the value of the car.
Markets for insurance, financial credit and
employment are also characterized by
asymmetric information about product quality
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The Market for Used Cars
 Assume
Two kinds of cars – high quality and low
quality
Buyers and sellers can distinguish between
the cars
There will be two markets – one for high
quality and one for low quality
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The Market for Used Cars
 High quality market
 SH is supply and DH is demand for high quality
 Low quality market
 SL is supply and DL is demand for low quality
 SH is higher than SL because owners of high
quality cars need more money to sell them
 DH is higher than DL because people are willing
to pay more for higher quality
©2005 Pearson Education, Inc.
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The Lemons Problem
PH
PL
SH
10,000
Market price for high quality cars
is $10,000
Market price for low quality cars is
$5000
50,000 of each type are sold
DH
SL
5,000
DL
DL
50,000
©2005 Pearson Education, Inc.
QH
Chapter 17
50,000
QL
6
The Market for Used Cars
 Sellers know more about the quality of the used
car than the buyer
 Initially buyers may think the odds are 50/50
that the car is high quality
 Buyers will view all cars as medium quality with
demand DM
 However, fewer high quality cars (25,000) and
more low quality cars (75,000) will now be sold
 Perceived demand will now shift
©2005 Pearson Education, Inc.
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The Lemons Problem
PH
Medium quality cars sell for $7500
selling 25,000 high quality and 75,000
low quality
PL
The increase in QL reduces expectations
and demand to DLM. The adjustment
process continues until demand = DL.
10,000
7,500
DH
7,500
DM
5,000
DM
DLM
DLM
DL
DL
25,000
50,000
©2005 Pearson Education, Inc.
QH
50,000
75,000
8 QL
The Market for Used Cars
 With asymmetric information:
Low quality goods drive high quality goods
out of the market- the lemons problem.
The market has failed to produce mutually
beneficial trade.
Too many low and too few high quality cars
are on the market.
Adverse selection occurs; the only cars on
the market will be low quality cars.
©2005 Pearson Education, Inc.
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Market for Insurance
 Older individuals have difficulty purchasing
health insurance at almost any price
 They know more about their health than the
insurance company
 Because unhealthy people are more likely to
want insurance, proportion of unhealthy people
in the pool of insured people rises
 Price of insurance rises so healthy people with
low risk drop out – proportion of unhealthy
people rises increasing price more
©2005 Pearson Education, Inc.
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Market for Insurance
 If auto insurance companies are targeting a
certain population – males under 25
 They know some of the males have low
probability of getting in an accident and some
have a high probability
 If can’t distinguish among insured, it will base
premium on the average experience
 Some with low risk will choose not to insure and
with raises the accident probability and rates
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Market for Insurance
 A possible solution to this problem is to
pool risks
Health insurance – government takes on role
as with Medicare program
Insurance companies will try to avoid risk by
offering group health insurance policies at
places of employment and thereby spreading
risk over a large pool
©2005 Pearson Education, Inc.
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Importance of Reputation and
Standardization
 Asymmetric Information and Daily Market
Decisions
Retail sales – return policies
Antiques, art, rare coins – real or counterfeit
Restaurants – kitchen status
©2005 Pearson Education, Inc.
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Implications of Asymmetric
Information
 How can these producers provide highquality goods when asymmetric
information will drive out high-quality
goods through adverse selection.
Reputation
Standardization
©2005 Pearson Education, Inc.
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Implications of Asymmetric
Information
 You look forward to a Big Mac when
traveling, even if you would not typically
buy one at home, because you know
what to expect.
 Holiday Inn once advertised “No
Surprises” to address the issue of
adverse selection.
©2005 Pearson Education, Inc.
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Market Signaling
 The process of sellers using signals to
convey information to buyers about the
product’s quality.
 For example, how do workers let
employers know they are productive so
they will be hired?
©2005 Pearson Education, Inc.
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Market Signaling
 Weak signal could be dressing well
 Strong Signal
To be effective, a signal must be easier for
high quality sellers to give than low quality
sellers.
Example: Highly productive workers signal
with educational attainment level.
©2005 Pearson Education, Inc.
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Model of Job Market Signaling
 Assume two groups of workers
Group I: Low productivity
 Average
Product & Marginal Product = 1
Group II: High productivity
 Average
Product & Marginal Product = 2
The workers are equally divided between
Group I and Group II
 Average
©2005 Pearson Education, Inc.
Product for all workers = 1.5
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Model of Job Market Signaling
 Competitive Product Market
P = $10,000
Employees average 10 years of employment
Group I Revenue = $100,000
 (10,000/yr.
x 10 years)
Group II Revenue = $200,000
 (20,000/yr.
©2005 Pearson Education, Inc.
X 10 years)
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Model of Job Market Signaling
 With Complete Information
w = MRP
Group I wage = $10,000/yr.
Group II wage = $20,000/yr.
 With Asymmetric Information
w = average productivity
Group I & II wage = $15,000
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Model of Job Market Signaling
 If use signaling with education
y = education index (years of higher
education)
C = cost of attaining educational level y
Group I  CI(y) = $40,000y
Group II  CII(y) = $20,000y
©2005 Pearson Education, Inc.
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Model of Job Market Signaling
 Cost of education is greater for the low
productivity group than for high
productivity group
Low productivity workers may simply be less
studious
Low productivity workers progress more
slowly through degree program
©2005 Pearson Education, Inc.
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Model of Job Market Signaling
 Assume education does not increase
productivity with only value as a signal
 Find equilibrium where people obtain
different levels of education and firms
look at education as a signal
 Decision Rule:
y* signals GII and wage = $20,000
Below y* signals GI and wage = $10,000
©2005 Pearson Education, Inc.
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Model of Job Market Signaling
 Decision Rule:
Anyone with y* years of education or more is
a Group II person offered $20,000
Below y* signals Group I and offered a wage
of $10,000
 y* is arbitrary, but firms must identify
people correctly
©2005 Pearson Education, Inc.
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Model of Job Market Signaling
 How much education will individuals
obtain given that firms use this decision
rule?
 Benefit of education B(y) is increase in
wage associated with each level of
education
 B(y) initially 0 which is the $100,000 base
10 year earnings
Continues to be zero until reach y*
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Model of Job Market Signaling
 There is no reason to obtain an
education level between 0 and y*
because earnings are the same
 Similarly, there is no incentive to obtain
more than y* level of education because
once hit the y* level of pay, there are no
more increases in wages
©2005 Pearson Education, Inc.
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Model of Job Market Signaling
 How much education to choose is a
benefit cost analysis
 Goal: obtain the education level y* if the
benefit (increase in earnings) is at least
as large as the cost of the education
 Group I:
$100,000 < $40,000y*, y* >2.5
 Group II:
$100,000 < $20,000y*, y* < 5
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Model of Job Market Signaling
 This is an equilibrium as long as y* is between
2.5 and 5
 If y* = 4
 People in group I will find education does not pay and
will not obtain any
 People in group II will find education DOES pay and
will obtain y* = 4
 Here, firms will read the signal of education and
pay each group accordingly
©2005 Pearson Education, Inc.
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Signaling
Group I
Value of
College
Educ.
$200K
Value of
College
Educ.
Group II
$200K
CI(y) = $40,000y
$100K
CII(y) = $20,000y
$100K
B(y)
0
1
2
3
4
Optimal choice of
©2005 Pearson
Education,
Inc.
y*
y for Group
I
5
6
B(y)
Years of
College
0
1
2
3
Optimal choice of
y for Group II
4
y*
5
6
Years of
College
29
Signaling
 Education does increase productivity and
provides a useful signal about individual
work habits even if education does not
change productivity.
©2005 Pearson Education, Inc.
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Market Signaling
 Guarantees and Warranties
Signaling to identify high quality and
dependability
Effective decision tool because the cost of
warranties to low-quality producers is too
high
©2005 Pearson Education, Inc.
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Moral Hazard
 Moral hazard occurs when the insured
party whose actions are unobserved can
affect the probability or magnitude of a
payment associated with an event.
If my home is insured, I might be less likely
to lock my doors or install a security system
Individual may change behavior because of
insurance – moral hazard
©2005 Pearson Education, Inc.
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Moral Hazard
 Moral hazard is not only a problem for
insurance companies, but it alters the
ability of markets to allocate resources
efficiently.
 Consider the demand (MB) of driving
If there is no moral hazard, marginal cost of
driving is MC
Increasing miles will increase insurance
premium and the total cost of driving
©2005 Pearson Education, Inc.
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The Effects of Moral Hazard
Cost
per
Mile
With moral hazard
insurance companies cannot
measure mileage. MC goes to$1.00 and
miles driven increases to 140
miles/week – Inefficient allocation.
$2.00
$1.50
MC (no moral hazard)
$1.00
MC’ (w/moral hazard)
$0.50
D = MB
50
©2005 Pearson Education, Inc.
100
140
Chapter 17
Miles per Week
34
The Principal – Agent Problem
 Owners cannot completely monitor their
employees – employees are better
informed than owners
 This creates a principal-agent problem
which arises when agents pursue their
own goals, rather than the goals of the
principal.
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The Principal – Agent Problem
 Company owners are principals.
 Workers and managers are agents.
 Owners do not have complete knowledge.
 Employees may pursue their own goals
even at a cost of reduce profits.
©2005 Pearson Education, Inc.
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The Principal – Agent Problem
 The Principal – Agent Problem in Private
Enterprises
Only 16 of 100 largest corporations have
individual family or financial institution
ownership exceeding 10%.
Most large firms are controlled by
management.
Monitoring management is costly
(asymmetric information).
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The Principal – Agent Problem –
Private Enterprises
 Managers may pursue their own
objectives.
Growth and larger market share to increase
cash flow and therefore perks to the
manager
Utility from job from profit and from respect of
peers, power to control corporation, fringe
benefits, long job tenure, etc.
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The Principal – Agent Problem –
Private Enterprises
 Limitations to managers’ ability to deviate
from objective of owners
Stockholders can oust managers
Takeover attempts if firm is poorly managed
Market for managers who maximize profits –
those that perform get paid more so incentive
to act for the firm
©2005 Pearson Education, Inc.
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The Principal – Agent Problem –
Private Enterprises
 The problem of limited stockholder
control shows up in executive
compensation
Business Week showed that average CEO
earned $13.1 million and has continued to
increase at a double-digit rate
For 10 public companies led by highest paid
CEOs, there was negative correlation
between CEO pay and company
performance
©2005 Pearson Education, Inc.
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CEO Salaries
Workers
CEOs
1970
$32,522
$1.3 Mil.
1999
$35,864
$37.5 Mil.
 CEO compensation has gone from 40
times the pay of average worker to over
1000 times
©2005 Pearson Education, Inc.
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CEO Salaries
 Although originally thought that executive
compensation reflected reward for talent,
recent evidence suggests managers
have been able to manipulate boards to
extract compensation out of line with
economic contribution
©2005 Pearson Education, Inc.
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The Principal – Agent Problem
 Limitations to Management Power
Managers choose a public service position
Managerial job market
Legislative and agency oversight (GAO &
OMB)
Competition among agencies
©2005 Pearson Education, Inc.
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Incentives in the Principal-Agent
Framework
 Designing a reward system to align the
principal and agent’s goals--an example
Watch manufacturer
Uses labor and machinery
Owners goal is to maximize profit
Machine repairperson can influence reliability
of machines and profits
©2005 Pearson Education, Inc.
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Incentives in the Principal-Agent
Framework
 Designing a reward system to align the
principal and agent’s goals--an example
Revenue also depends, in part, on the quality
of parts and the reliability of labor.
High monitoring cost makes it difficult to
assess the repair-person’s work
©2005 Pearson Education, Inc.
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