Chapter 19
Asymmetric
Information
Topics
•  Problems Due to Asymmetric
Information.
•  Responses to Adverse Selection.
•  How Ignorance About Quality Drives
Out High-Quality Goods.
•  Price Discrimination Due to False
Beliefs About Quality.
•  Market Power from Price Ignorance.
•  Problems Arising from Ignorance
When Hiring.
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Asymmetric Information
•  Asymmetric information - situation in
which one party to a transaction knows a
material fact that the other party does not.
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Problems Due to Asymmetric Information
•  Adverse selection - opportunism
characterized by an informed person’s
benefiting from trading or otherwise
contracting with a less-informed person
who does not know about an unobserved
characteristic of the informed person.
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Problems Due to Asymmetric Information
•  Moral hazard - opportunism
characterized by an informed person’s
taking advantage of a less informed
person through an unobserved action.
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Responses to Adverse Selection
•  Restricting opportunistic behavior
•  Equalizing information
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Controlling Opportunistic Behavior
Through Universal Coverage
•  Adverse selection can be prevented if
informed people have no choice.
•  A government can avoid adverse
selection by providing insurance to
everyone or by mandating that everyone
buy insurance.
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Equalizing Information
•  Screening - an action taken by an
uninformed person to determine the
information possessed by informed
people.
•  Signaling - an action taken by an
informed person to send information to an
uninformed person.
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Lemons Market with Fixed Quality
•  When buyers cannot judge a product’s
quality before purchasing it, low-quality
products—lemons—may drive highquality products out of the market.
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Lemons Market with Fixed Quality (cont.)
•  Cars that appear to be identical on the
outside often differ substantially in the
number of repairs they will need.
w Some cars —lemons— have a variety of
insidious problems that become apparent to
the owner only after the car has been driven
for a while.
w The seller of a used car knows from
experience whether the car is a lemon.
w We assume that the seller cannot alter the
quality of the used car
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Lemons Market with Fixed Quality (cont.)
•  Suppose that there are many potential
buyers for used cars.
•  All are willing to pay $1,000 for a lemon
and $2,000 for a good used car.
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Lemons Market with Fixed Quality (cont.)
•  1,000 owners of lemons and 1,000 owners
of good cars are willing to sell.
w The reservation price of owners of lemons—
the lowest price at which they will sell their
cars—is $750.
•  The reservation price of owners of highquality used cars is v, which is less than
$2,000.
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Figure 19.1 Markets for Lemons and
Good Cars
Pr ice of a lemon, $
SL
750
e
1,000
0
f
1,500
D*
1,000
1,750
1,500
1,250
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E
2,000
DL
Lemons per year
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(b) Ma rket for Good Cars
Pr ice of a good ca r, $
(a) Ma rket for Lemons
0
S2
F
DG
D*
S1
1,000
Good cars per year
Symmetric Information
•  If both sellers and buyers know the quality
of all the used cars before any sales take
place, all the cars are sold, and good cars
sell for more than lemons.
This market is efficient because the goods
go to the people who value them the most.
All the cars are sold if everyone has the
same information.
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Symmetric Information
•  The amount of information they have
affects the price at which the cars sell.
w If no one can tell a lemon from a good car at
the time of purchase, both types of cars sell for
the same price.
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Symmetric Information
•  Suppose that everyone is risk neutral and
no one can identify the lemons: Buyers
and sellers are equally ignorant.
w A buyer has an equal chance of buying a
lemon or a good car.
w The expected value of a used car is
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Symmetric Information
•  This market is efficient because the cars
go to people who value them more than
their original owners.
Sellers of good-quality cars are implicitly
subsidizing sellers of lemons.
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Asymmetric Information
•  If sellers know the quality but buyers do
not, this market may be inefficient:
w The better-quality cars may not be sold even
though buyers value good cars more than
sellers do.
w The equilibrium in this market depends on
whether the value that the owners of good
cars place on their cars, v, is greater or less
than the expected value of buyers, $1,500.
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Asymmetric Information (cont.)
•  There are two possible equilibria:
w All cars sell at the average price, or
w only lemons sell for a price equal to the value
that buyers place on lemons.
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Asymmetric Information (cont.)
•  Consequently, asymmetric information
does not cause an efficiency problem,
w but it does have equity implications.
w Sellers of lemons benefit and sellers of good
cars suffer from consumers’ inability to
distinguish quality.
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Asymmetric Information (cont.)
•  Now suppose that the sellers of good cars place
a value of v = $1,750 on their cars and thus are
unwilling to sell them for $1,500.
w  As a result, the lemons drive good cars out of the
market.
w  Buyers realize that, at any price less than $1,750,
they can buy only lemons.
w  Consequently, in equilibrium, the 1,000 lemons sell
for the expected (and actual) price of $1,000, and no
good cars change hands.
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Asymmetric Information (cont.)
•  This equilibrium is inefficient because
high-quality cars remain in the hands of
people who value them less than potential
buyers do.
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Solved Problem 19.1
•  Suppose that everyone in our used-car example
is risk neutral, potential car buyers value lemons
at $1,000 and good used cars at $2,000, the
reservation price of lemon owners is $750, and
the reservation price of owners of high-quality
used cars is $1,750.The share of current
owners who have lemons is θ [in our previous
example, the share was θ = 1/2 = 1,000/(1,000
+ 1,000)]. For what values of θ do all the
potential sellers sell their used cars? Describe
the equilibrium.
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Solved Problem 19.2
•  Suppose that it costs $10 to produce a lowquality book bag and $20 to produce a highquality bag, consumers cannot distinguish
between the products before purchase, there
are no repeat purchases, and consumers value
the bags at their cost of production. The five
firms in the market produce 100 bags each.
Each firm produces only high-quality or only
low-quality bags. Consumers pay the expected
value of a bag. Do any of the firms produce
high-quality bags?
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Solved Problem 19.2
•  If one firm makes a high-quality bag and
all the others make low-quality bags, the
expected value per bag to consumers is
w Thus, if one firm raises the quality of its
product, all firms benefit because the bags
sell for $12 instead of $10.
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Solved Problem 19.2
•  Because the high-quality firm incurs all
the expenses of raising quality, $10 extra
per bag, and reaps only a fraction, $2, of
the benefits, it opts not to produce the
high-quality bags.
•  Therefore, due to asymmetric information,
the firms do not produce high-quality
goods even though consumers are willing
to pay for the extra quality.
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Limiting Lemons
• 
• 
• 
• 
• 
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Laws to Prevent Opportunism
Consumer Screening
Third-Party Comparisons
Standards and Certification
Signaling by Firms
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Price Discrimination Due to False Beliefs
About Quality
•  One way in which firms confuse
consumers is to create noise by selling
virtually the same product under various
brand names.
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Market Power from Price Ignorance
•  Suppose that many stores in a town sell
the same good.
w If consumers have full information about
prices, all stores charge the full-information
competitive price, p*.
w If one store were to raise its price above p*,
the store would lose all its business.
w Each store faces a residual demand curve
that is horizontal at the going market price
and has no market power.
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Market Power from Price Ignorance
(cont.)
•  If consumers have limited information
about the price that firms charge for a
product, one store can charge more than
others and not lose all its customers.
w Customers who do not know that the product
is available for less elsewhere keep buying
from the high-price store.
w Thus, each store faces a downward-sloping
residual demand curve and has some market
power.
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Tourist-Trap Model
•  You arrive in a small town near the site of the discovery
of gold in California. Souvenir shops crowd the street.
Wandering by one of these stores, you see that it sells
the town’s distinctive snowy: a plastic ball filled with
water and imitation snow featuring a model of the
Donner Party. You instantly decide that you must buy at
least one of these tasteful mementos—perhaps more if
the price is low enough. Your bus will leave very soon,
so you can’t check the price at each shop to find the
lowest price. Moreover, determining which shop has the
lowest price won’t be useful to you in the future because
you do not intend to return anytime soon.
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Tourist-Trap Model (cont.)
•  Let’s assume that you and other tourists
have a guidebook that reports how many
souvenir shops charge each possible
price for the snowy, but the guidebook
does not state the price at any particular
shop. There are many tourists in your
position, each with an identical demand
function.
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Tourist-Trap Model (cont.)
•  It costs each tourist c in time and
expenses to visit a shop to check the
price or buy a snowy.
w Thus, if the price is p, the cost of buying a
snowy at the first shop you visit is p + c.
w If you go to two souvenir shops before buying
at the second shop, the cost of the snowy is p
+ 2c.
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When Price Is Not Competitive
•  Will all souvenir shops charge the same
price?
w If so, what price will they charge?
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When Price Is Not Competitive
•  If all other shops charge p*, a firm can
profitably charge p1 = p* + ε,
w where ε, a small positive number, is the
shop’s price markup.
•  If consumers have limited information
about price, an equilibrium in which all
firms charge the full-information,
competitive price is impossible.
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Monopoly Price
•  Can there be an equilibrium in which all
stores charge the same price and that
price is higher than the competitive price?
w The monopoly price may be an equilibrium
price.
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Monopoly Price
When consumers have asymmetric
information and when search costs and
the number of firms are large, the only
possible single-price equilibrium is at the
monopoly price.
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Solved Problem 19.3
•  Initially, there are many souvenir shops,
each of which charges pm (because
consumers do not know the shops’
prices), and buyers’ search costs are c. If
the government pays for half of
consumers’ search costs, can there be a
single-price equilibrium at a price less
than pm?
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Problems Arising from Ignorance
When Hiring
•  Asymmetric information is frequently a
problem in labor markets.
•  Prospective employees may have less
information about working conditions than
firms do.
•  firms may have less information about
potential employees’ abilities than the
workers do.
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Cheap Talk
•  When an informed person voluntarily
provides information to an uninformed
person, the informed person engages in:
w cheap talk - unsubstantiated claims or
statements
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Cheap Talk (cont.)
•  Suppose that a firm plans to hire Cyndi to
do one of two jobs.
w The demanding job requires someone with
high ability.
w The undemanding job can be done better by
someone of low ability because the job bores
more able people, who then perform poorly.
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Table 19.1 Employee-Employer Payoffs
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Cheap Talk (cont.)
•  If it gives her the undemanding job, the firm’s
expected payoff is:
⎛1 ⎞ ⎛1
⎞
⎜ × 1⎟ + ⎜ × 4 ⎟ = 2.5
⎝2 ⎠ ⎝2
⎠
•  If it gives her the demanding job, the firm’s
expected payoff is:
⎛1
⎞ ⎛1 ⎞
⎜ × 2 ⎟ + ⎜ × 1⎟ = 1.5
⎝2
⎠ ⎝2 ⎠
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Education as a Signal
•  If high-ability people are more likely to go
to college than low-ability people,
schooling signals ability to employers
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Education as a Signal (cont.)
•  Extreme assumptions that
w  graduating from an appropriate school serves as the
signal and
w  that schooling provides no training that is useful to
firms
•  High-ability workers are θ share of the
workforce, and low-ability workers are 1 − θ
share.
•  The value of output that a high-ability worker
produces for a firm is worth wh, and that of a
low-ability worker is wl (over their careers).
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Education as a Signal (cont.)
•  Pooling equilibrium - an equilibrium in which
dissimilar people are treated (paid) alike or
behave alike.
•  Employers pay all workers the average wage:
w = θ wh + (1 − θ ) wl
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Education as a Signal (cont.)
•  We assume that
w high-ability individuals can get a degree by
spending c to attend a school and
w that low-ability people cannot graduate from
the school
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Education as a Signal (cont.)
•  Separating equilibrium - an equilibrium
in which one type of people takes actions
(such as sending a signal) that allows
them to be differentiated from other types
of people
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Education as a Signal (cont.)
•  In a separating equilibrium,
w high-ability people pay c to get a degree and
are employed at a wage of wh,
w while low-ability individuals do not get a
degree and work for a wage of wl.
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Education as a Signal (cont.)
•  Rearranging terms in the previous
expression, we find that a high-ability
person chooses to get a degree if
wh − wl > c.
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Pooling Equilibrium
•  In a pooling equilibrium, all workers are paid the
average wage.
•  It does not pay for the high-ability person to
graduate if the benefit from graduating, the extra
pay is less than the cost of schooling:
wh − w < c
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Solved Problem 19.4
•  For what values of θ is a pooling
equilibrium possible in general? In
particular, if c = $15,000, wh = $40,000, and
wl = $20,000, for what values of θ is a
pooling equilibrium possible?
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Unique or Multiple Equilibria
•  Depending on differences in abilities, the
cost of schooling, and the share of highability workers, only one type of
equilibrium may be possible or both may
be possible.
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Figure 19.2 Pooling and
Separating Equilibria
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Efficiency
•  In our example of a separating
equilibrium, high-ability people get an
otherwise useless education solely to
show that they differ from low-ability
people.
•  Signaling changes the distribution of
wages:
w Instead of everyone getting the average
wage, high-ability workers receive more pay
than low-ability workers.
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Figure 19.2 Pooling and
Separating Equilibria (cont.)
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Efficiency
Total social output falls with signaling if
signaling is socially unproductive but may
rise with signaling if signaling also raises
productivity or serves some other
desirable purpose.
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Screening in Hiring
•  Firms screen prospective workers in many
ways.
w Interviews and Tests
w Statistical Discrimination
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Figure 19.3 Statistical Discrimination
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Challenge Solution: Dying to Work
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