L25
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Transcript of L25
L25
Asymmetric Information
Road map1) Consumers choice
2) Equilibrium, Producers
(Pareto efficiency)
3) Market Failures
- fixed cost: monopoly and oligopoly
- externalities and public goods
- asymmetric information
Asymmetric Information Assumption: full information about the
traded commodities
What about following markets? 1. Medical services: a doctor knows more
than does the patient.2. Insurance: buyer knows more about
his riskiness than does the seller. 3. Used cars: a car’s owner knows more
about it than does a potential buyer
Problem: asymmetric information
Today
Q: how does asymmetric information affect the functioning of a market?
Important phenomena0 adverse selection (hidden information)0 signaling 0 moral hazard (hidden action)
Market for “lemons”
Second hand car market. Types of cars: “lemons” and “plums”.
Benchmark: Perfect information
Gains-to-Trade (50% - 50%)
Lemon Plum
Seller 1000 2000
Buyer 1200 2400
Asymmetric information
Asymmetric information (50% - 50%)
Gains-to-trade and BS, SS
Lemon Plum
Seller 1000 2000
Buyer 1200 2400
Separating equilibrium
Asymmetric information ( , )
Lemon Plum
Seller 1000 2000
Buyer 1200 2400
1
Pooling equilibrium
Asymmetric information ( , )
Gains-to-trade BS and SS
Lemon Plum
Seller 1000 2000
Buyer 1200 2400
1
Adverse Selection
Separating equilibrium “too many” lemons “crowd out” the plums from the market. gains-to-trade are reduced since no plums are traded Bad for plum owners
Pooling equilibrium Lemon owners “hide behind” the plums Somewhat bad for plum owners Pareto efficiency
Probability of “bad type” is high: compulsory insurance
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Signaling
Asymmetric information bad for “good” types
Incentive: Credible signal of high-quality
Examples of signals: warranties, professional credentials, references from previous clients, costly adds, education etc.
Signaling (in Labor Market) Two types of managers
- high-ability manager has productivity (a plum)
- low-ability manager has productivity (a lemon) Fraction of high-productivity managers
Competitive markets
Benchmark: No signal (pooling)
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( | )w E a I
1ha 0la
Equilibrium with signaling
Signal: MBA education Managers can chose the level of education
Cost of education (MBA) For high-ability worker education costless For low-ability worker
Benefit of education MBA has no effect on workers’ productivities Talent not observed but MBA diploma yes - signal It is a deadweight loss
Q: Is there a separating equilibrium with signaling?
( ) 0h hc e ( ) 0.2l l lc e e
,l he e
(Non) Credible signal
Can we separate with e=2?
1, 0, ( ) 0, ( ) 0.2h l h h l l la a c e c e e
(Non) Credible signal
Credibility condition
1, 0, ( ) 0, ( ) 0.2h l h h l l la a c e c e e
A credible signal
Can we separate now?
Signal more costly to low type Deadweight loss (burning money) Common in real world: adds
1, 0, ( ) 0.1 , ( ) 0.2h l h h h l l la a c e e c e e
Moral Hazard (hidden action)
With full car insurance are you more likely to leave your car unlocked?
With fixed hourly wage is your effort at work reduced?
Moral hazard is a reaction to incentives to increase the risk of a loss
A consequence of asymmetric information (hidden action).
Moral hazard
Perfect information: full insurance Asymmetric information:- partial insurance- contract that depends on output
To assume proper incentives