Introductory to
Microeconomics
1st edition
Chapter 17
Asymmetric
information
Wyn Morgan
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Introduction
• In many transactions, the people
involved have different amounts of
information.
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Introduction
• As well as many other situations in
which one side of deal knows
something that the other does not, e.g.
buying used car or when a firm hires a
new employee!
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Introduction
• As well as many other situations in
which one side of deal knows
something that the other does not, e.g.
buying used car or when a firm hires a
new employee!
• Where one side know more than the
other we have ‘asymmetric information’.
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Asymmetric information
• The existence of asymmetric gives rise
to:
• Hidden characteristics
• Hidden actions
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Hidden characteristics
• Whenever one side of the a transactions
knows something about itself that the
other side does not know, we have
‘hidden characteristics’.
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Hidden actions
• Whenever one die of the an economic
relationship takes actions that the other
side cannot observe is a situation of
‘hidden cost’.
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Signalling and screening
• We next examine the effects of hidden
characteristics on the operation and
performance of markets.
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Another look at discrimination
• Typically consumers know how much
they are willing to pay for a good, but
the firm selling to them does not!
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Another look at discrimination
• Typically consumers know how much
they are willing to pay for a good, but
the firm selling to them does not!
• The firm would like to know what
customers are prepared to pay:
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Another look at discrimination
• Typically consumers know how much
they are willing to pay for a good, but
the firm selling to them does not!
• The firm would like to know what
customers are prepared to pay:
• Via signals and screening
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Normative analysis of second
degree price discrimination
• When possible, second degree price
discrimination can raise the sellers
profits.
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Normative analysis of second
degree price discrimination
• When possible, second degree price
discrimination can raise the sellers
profits.
• The question here is what happens to
total surplus when price changes?
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Normative analysis of second
degree price discrimination
• When possible, second degree price
discrimination can raise the sellers
profits.
• The question here is what happens to
total surplus when price changes?
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Normative analysis of second
degree price discrimination
• When possible, second degree price
discrimination can raise the sellers
profits.
• The question here is what happens to
total surplus when price changes?
• This gives rise to:
• Allocate efficiency
• Welfare effects
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Competitive market signalling
• Under second degree price
discrimination, a firm with market
power uses a signal to sort consumers
and discriminate among them!
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Competitive market signalling
• Under second degree price
discrimination, a firm with market
power uses a signal to sort consumers
and discriminate among them!
• The use of signals also can be an
important phenomenon in competitive
markets.
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Competitive market signalling
- example
• The example considered here is one low
ability and high ability workers (Spence
1974)
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Competitive market signalling
- example
• The example considered here is one low
ability and high ability workers (Spence
1974)
• The question that arises here is:
• Why consumer education?
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Competitive market signalling
- example
• The answer must be that there are
some offsetting benefits from
consuming education despite the initial
costs involved!
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The income-budget curve
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Equilibrium education choice
for high ability worker
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What about the low ability
worker?
• By assumption, the disutility of going to
university is higher for these workers.
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What about the low ability
worker?
• By assumption, the disutility of going to
university is higher for these workers.
• Therefore, the low ability person needs
greater compensation for getting
through an additional year of education
than for the high ability person, ceteris
paribus.
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Equilibrium education choice
for a low ability worker
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Normative analysis of
education as a signal
• The question here how does the use of
education as a signal affect the surplus
of different types of workers?
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Normative analysis of
education as a signal
• The question here how does the use of
education as a signal affect the surplus
of different types of workers?
• Note that high ability worker’s wages
rise because of more schooling.
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Normative analysis of
education as a signal
• The question here how does the use of
education as a signal affect the surplus
of different types of workers?
• Note that high ability worker’s wages
rise because of more schooling.
• And that low ability workers are low
because of less schooling.
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Normative analysis of
education as a signal
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Id education really just a
signal?
• The conclusion here is that education as
a signal are very disturbing to many
people and important to consider:
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Id education really just a
signal?
• The conclusion here is that education as
a signal are very disturbing to many
people and important to consider:
– Wages rise with more schooling
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Id education really just a
signal?
• The conclusion here is that education as
a signal are very disturbing to many
people and important to consider:
– Wages rise with more schooling
– The model may lead to too a special
outcome to lead to any real outcome
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Adverse selection
• In some markets, the very fact that the
informed party wants to deal with the
uninformed party can serve as signal!
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More on insurance markets!
• The question, here, is how much
insurance to buy?
• What if the probability of the negative
outcome being observes increases but
this is not communicated to the
insurance company – what happens?
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More on insurance markets!
• The analysis can be done on two fronts:
• The full information equilibrium
• Partial information available
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More on insurance markets!
• The analysis can be done on two fronts:
• The full information equilibrium
• Partial information available
• The asymmetric information equilibrium
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Full information equilibrium illustrated
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Partial information - illustrated
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Asymmetric information
equilibrium
• Here the situation is that the person
taking out the insurance does not
inform the insurance company of the
full facts!
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Asymmetric information
equilibrium - illustrated
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Asymmetric information
equilibrium
• When tastes differ such that an
individual is prepared to drop out of the
market what happens then?
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Asymmetric information
equilibrium - illustrated
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Asymmetric information
equilibrium - illustrated
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Market responses to adverse
selection
• We have seen thus far that asymmetric
information can be adverse
consequences for efficiency.
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Market responses to adverse
selection
• We have seen thus far that asymmetric
information can be adverse
consequences for efficiency.
• Examples here would be:
• Insurance and testing for AIDS
• Group health plans
• Targeted insurance rates
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Other markets in which
adverse selection is important
• Adverse selection is not just confined to
insurance markets. It can be applied to:
• Labour markets
• The market for human blood (Politis, 2000)
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Government responses to
hidden characteristics
• Hidden characteristics may fall short of
achieving efficient outcomes if everyone
were to be fully informed.
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Government responses to
hidden characteristics
• Hidden characteristics may fall short of
achieving efficient outcomes if everyone
were to be fully informed.
• This raises the possibility that
government intervention could
intervene and improve matters!
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Government responses to
hidden characteristics
• Example of this is:
• Compulsory public pension programmes
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Government responses to
hidden characteristics
• Example of this is:
• Compulsory public pension programmes
• Informational disseminating policies
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Hidden actions
• Since by its very nature where
information is limited we have hidden
actions.
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Hidden actions
• Since by its very nature where
information is limited we have hidden
actions.
• The question how can these hidden
actions be revealed?
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Hidden actions
• Since by its very nature where
information is limited we have hidden
actions.
• The question how can these hidden
actions be revealed?
Answer –principal agent relationship!
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Hidden actions
‘To get individuals to take the right action,
the contract has to give the individual
the right incentives’
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Moral hazard in insurance
markets
• The problem of hidden actions is that
individual’s decisions are distorted!
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Moral hazard in insurance
markets
• The problem of hidden actions is that
individual’s decisions are distorted!
• Examples when moral hazard is
present:
• Fire prevention in the absence of insurance
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No insurance - illustrated
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With insurance - illustrated
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Moral hazard and insurance example
• The effect of moral hazard is most
dramatic when the homeowner overinsures to get more money for the
property if it burns down than by selling
it on the open market
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Efficiency effects of moral
hazard
• Sometimes people damage their own
property to claim the insurance
payment!
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Efficiency effects of moral
hazard
• Sometimes people damage their own
property to claim the insurance
payment!
• Clearly burning the property down to
collect on the insurance is wasteful and
inefficient, isn’t it?
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Efficiency effects of moral
hazard
• Not really as it reduces the ‘care levels’!
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Co-insurance and deductibles
• The problem of moral hazard arises
because insurance reduces the
incentives for care.
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Co-insurance and deductibles
• The problem of moral hazard arises
because insurance reduces the
incentives for care.
• One way mitigate this problem is to
reduce the level of insurance and
require the policy holder to bear some
of the costs of a claim.
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Co-insurance and deductibles
• Many insurance policies have what is
known as ‘co-insurance’.
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Co-insurance and deductibles
• Many insurance policies have what is
known as ‘co-insurance’.
• Another example of making the policy
holder bear some of the risk is to have
‘an excess’ or ‘deductible’.
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Employer-employee
relationships
• Problem of moral hazard are important
in many other employer-employee
relationship.
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Employer-employee
relationships
• Problem of moral hazard are important
in many other employer-employee
relationship.
• The question is how does the manager
know that his workers are all working
efficiently and not shirking?
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Employer-employee
relationships
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Observable shirking
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Observable shirking
• If performance cannot be observed
what can management do?
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Observable shirking
• If performance cannot be observed
what can management do?
• Management could consider:
• A flat salary
• Performance based compensation
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A flat salary approach
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Performance-based
compensation
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Two puzzles
• The theory thus far suggest that
performance based schemes are
superior to flat salaries!
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Two puzzles
• Now, since managers are on fixed
salaries and not paid the pure residual
we have the following questions:
• Why do people paid on salary do ant work?
• If residual claimant contracts have such good
incentive properties, why are not all contracts
of this form?
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Moral hazard in product
markets
• Sometimes you pay for something
without knowing exactly what you are
getting for your money!
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Moral hazard in product
markets
• Sometimes you pay for something
without knowing exactly what you are
getting for your money!
• There is thus the potential for moral
hazard problems because a firm can
reduce its costs by lowering its
product’s quality,which lowers consumer
welfare, ceteris paribus.
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