Lecture #7

Asymmetric information 1: adverse selection, signaling

Asymmetric information the situation when one of the parties to the transaction has more information than the other. Acquiring information is possible but very costly. Examples: • the seller knows more about the good than the buyer, • employees know more about their skills and talents than the employers, • the managers have more information about the production costs, the firm’s competitive position in the market, and investment potential, than the owners • insurers lack significant information about the insured, which is accessible to the latter.

Asymmetric information leads to erroneous market allocation!

• equilibrium may be not Pareto-optimal • equilibrium may not exist

Adverse selection

On the seller’s part: crowding a better product out of the market by a worse one; hidden information leads to insufficient supply of the high-quality product. On the buyer’s part: crowding better clients out by worse ones; increasing costs for the producer exclude the preceding ones from the market.

Example 1: used cars

• Assumptions: – 2 types of cars – high-quality and low-quality

(e.g. damaged in an accident) – temporary assumption: the buyers and

seelers can distinguish which car belongs to which group

– 2 markets will arise: for high-quality cars and for low-quality cars

Example 1: used cars (the case of complete information)

• high-quality cars market – SH – supply; DH – demand

• low-quality cars market – SL – supply; DL – demand

• SH < SL • DH > DL

Example 1: used cars; complete information

PH PL

QH QL

SH

SL

DH

DL

5 000

50 000 50 000

10 000

DL

Example 1: used cars (the case of asymmetric information) • Akerlof (1970) „Market for lemons”, Nobel 2001 • sellers know more about the quality of the cars

than buyers • initially buyers assume that 50% of the cars

available for sale are high-quality and 50% are low-quality

• buyers specify their demand based on average quality of a car DM

• in such case less high-quality cars will be sold (25 000)

• demand will adjust to this new level (shift downwards)

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Example 1: used cars; asymmetric information

PH PL

QH QL

DH

DL

5,000

50,000 50,000

10,000

DL

An increase in QL reduces expectations as to the quality of cars and demand to DLM. Such adjustment will take place up to the

point when demand = DL.

DM

25,000

7,500

75,000

7,500

DM

DLM

DLM

Example 1: used cars (the case of asymmetric information)

– lower-quality products crowd higher-quality

products out of the market – the market fails to supply mutually beneficial

transactions – too many low-quality cars are sold in the

market and not enough high-quality ones – adverse selection may lead to a situation,

when only low-quality cars are sold in the market

Example 1: used cars (the case of asymmetric information)

– in reality differences in the quality of the cars may not be so large

– owners may also lack complete information – quality verification by the buyer is possible but

costly – even with a low price the supply of high-

quality cars will not fall to 0 – however, comparing with the situation under

complete information, many high-quality cars will not be sold

Another example: baseball market

• players moving to a new MLB team are injured more often

Days on medical leave First

contract New

contract change

in % All 4.73 12.55 165.4

In the old team 4.76 9.68 103.4

In the new team 4.67 17.23 268.9

Yet another example: mergers and acquisitions

• Experiment 1: bying a company • Experiment 2: buying a jar • Groucho Marx Theorem: („I don’t want to belong

to any club that will have me as a member”) • the fact that we succeeded in acquiring a

company is a bad sign as regards its value • Asymmetric information eliminates part of the

benefits that could be gained from synergy effects, etc.

Example 2a: health and life insurance

• more willing to buy life and health insurance will be: – those whose health condition is bad, – those with unhealthy lifestyle – family members of those who suffer various health

problems – ...

• verifying such suspicions is costly for the insurer

Example 2b: motor vehicle insurance

• buyers of insurance differ in: – intensity of use of their car – driving skills – manner of driving – care for the car – their car’s technical condition – ...

• many of these characteristics are not observable for the insurer but are known to the insured

Example 3: loans

• a significant component of the costs of credit is the risk of default or delay in paying back the loan

• such risk depends on individual characteristics • unreliable, dishonest persons, having difficulties

in sustaining employment etc. may be more willing to take loans

• again, premiums rise, more reliable clients drop out

How to counteract adverse selection of clients/buyers?

• restrict voluntariness – mandatory insurance (role of the state, e.g. social

security) – selling group insurance to firms

• mitigate asymmetry of information – segregation into various risk groups (e.g. depending

on driver’s age, accident history, color of the car, etc.) – bonus-malus arrangements, credit history etc.

Avoiding adverse selection (the seller)

– reputation • rankings, information from others etc.

– standards • e.g. McDonald’s, Holiday Inn (“No Surprises”) etc.

– warranties • accepting complaints

– signalling quality • certificates, diplomas etc.

Signalling

• Question: How do potential employees convince employers about the quality of their services? – weak signalling: dress (used as easily by the

low-quality employees as by the high-quality ones)

– strong signalling: diploma (less effort required to obtain it by higher-quality employees, thank by the lower-quality ones)

Signalling

• assumption: 2 groups of employees: – group 1: low productivity

• APL = MPL = 1 – group 2: high productivity

• APL = MPL = 2 – groups 1 and 2 are of equal sizes

• APL for the joint group of employees = 1.5

Signalling

• purely competitive labor and product market – P = 10 000 Euro – employees hired based on 10-year contracts – group 1: TR = 100 000 Euro

• (1 x 10 000 x 10) – Group 2: TR = 200 000 Euro

• (2 x 10 000 x 10)

Signalling

• complete information – w = MRP – group 1: w = 10 000 Euro/year – group 2: w = 20 000 Euro/year

• asymmetric information – w = AP – group 1 & 2: w = 15 000 Euro/year – pooling equilibrium

Signalling

• Signalling – education level – y = number of years of university education – C = costs of education

• Fees, cost of books, effort, opportunity costs etc. – group 1 à C1(y) = 40000y Euro – group 2 à C2(y) = 20000y Euro

Signalling • costs of education are higher for the low-quality

employees – more effort, more expenses (e.g. private lessons,

fees for repeating the year) • decisions regarding remuneration (wage):

– y=y* signals that the employee belongs to group G2 and obtains remuneration (wage) = 20 000 Euro

– y below y* signals that the employee belongs to group G1 and obtains remuneration (wage) = 10 000 Euro

• y* is an arbitrary level, however must be identifiable by employers

Signalling

• how many years of education will both groups of employees choose?

• goal: obtaining such education level which assures that benefits from it will be higher than costs of obtaining it

• For group 1 it does not pay to study for y* years, i.e. – 100 000 < 40 000y*, y* > 2.5

• group 2 does study: – 100 000 > 20 000y*, y* < 5

Signalling

• there is no reason to study less than y* years because remuneration (wage) will then be the same as in the case of no education

• Similarly, there are no incentives to obtain education higher than y* because this will not cause an increase in the remuneration (wage)

Signalling • the equilibrium will be found within the interval of

y* between 2.5 and 5 • if y* = 4

– members of group 1, minimazing their costs, will not study

– for members of group 2 education will be remunerative up to 4 years of university studies y* = 4

• the employer will read the signals given by potential employees and employ them at adequate remuneration levels

(separating equilibrium)

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Signalling

Value of education

100K

Years of study

Years of study

0 1 2 3 4 5 6 0 1 2 3 4 5 6

200K

100K

200K C1(y) = 40 000y

B(y) B(y)

y* y*

C2(y) = 20 000y

optimal choice of y group 2

Group 2 Group 1

optimal choice of y group 1

Value of education

Other examples of signalling

• piles of books are a signal of quality

• because printing something of low quality in such large quantity could result in bankrupcy

• similarly: expenses on advertisement, marketing campaigns etc.

Signalling – summary

• education pays off even if everything that we/you learn during our/your studies is useless for our/your work

• the university diploma is a signal of talent and willingness to work hard

• vide: demand for physicists • in order to work, the signal must:

– be relatively costly for the ‟low quality” group – be understandable for both sides of the market