Microeconomics 2

John Hey

Asymmetric Information

• The seller of the good knows more about its quality than the buyer..

• Perhaps the market does not exist …• …or is inefficient.• Perhaps sellers need to signal the quality.• Perhaps that is why you are at university?• This lecture examines:

• the market for lemons;

• moral hazard;

• adverse selection;

• signalling and reputation.

A simple example: the market for used cars

• Two types: lemons and plums (each 50%).• Suppose that buyers cannot tell the difference.• Reservation prices:• Seller of a plum: 2000• Seller of a lemon: 1000• Buyer of a plum (recognised as such): 2400• Buyer of a lemon (recognised as such): 1200.• What will happen if a buyer cannot can tell

whether a car for sale is a plum or a lemon?• (In the book I use different numbers but the

argument is the same.)

A more complicated market

• Where there is a continuum of quality.• Supply increases with the price, as does

the quality.• There are two effects of the price on

demand: the usual – an increase in the price causes a fall in demand; and an indirect effect through the rising quality pushing up the demand for the good.

• Let us go to Maple...

Insurance market

• If the insurance company knows the probability of an accident…

• …there is not a problem.• But the existence of insurance changes the

probability (moral hazard)– or the insurance company does not know the probability (adverse selection) – there is a problem.

• It may be possible to solve this second problem with a separating equilibrium.

Other methods

• Guarantees

• Reputation.

• Experience.

• Signals.

• Usually we have to have repetitions,

• Note the high prices and low quality in tourists markets.

Signaling

• Two kinds of workers: unable (1) and able (2) with marginal productivities a1 and a2. (a1<a2). Propn. b able.

• If distinguishable, firm pays a1 to unable and a2 to able.• If not distinguishable, firm offers wage (1-b)a1+b a2. OK?• Consider education e1 and e2 with costs c1e1 and c2e2 .• Suppose c2<c1 – it is less costly/easier for the able. ***• Suppose e* is such that• (a2-a1)/c1 < e* < (a2-a1)/c2 (which must be possible)• Firm pays a2 to those with education e*, and a1 to those with

education 0.• The unable choose e=0; the able choose e=e*. (Why?)• Is this an equilibrium? Is this why you are at University?

Why are you here?

• …to learn?• …to have fun?• …to avoid serious work (for the moment)?• ...because you do not know what you want out of life?• …to get a signal (your degree, your mark) of your

quality?• To be useful such a signal must be informative: the

higher the mark the better the student. • That is why I examine this module the way that I do. • My exams are not tests of memory ...• ... they are tests of ability/understanding.

Lecture 34

• Goodbye!