Asymmetric Information

Perloff Chapter 19
 Asymmetric Information
When two parties to a transaction have different
information.
Adverse Selection
When an informed person has an advantage through an
unobserved characteristic.
Eg a disproportionately large number of unhealthy
people buy life insurance.
Moral Hazard
When an informed person has an advantage through an
unobserved action.
An insured car driver drives faster.
 Equalising information
Screening
Obtaining information about hidden characteristics.
Insurance.
Costly.
Signalling
Use of public information to indicate the nature of
private information.
Restaurant.
 Market for lemons and good cars
(a) Market for Lemons (b) Market for Good Cars
Price of a lemon, $

Price of a good car, $

SL
E
2,000 DG
1,750
f S2 F
1,500 D* 1,500 D*
1,250
e S1
1,000 DL
750

0 1,000 0 1,000
Lemons per year Good cars per year
 Preventing the occurrence of lemon
markets
Laws Standards and
Product liability laws, certification,
Consumer screening Kite marks,
The use of a mechanic, Signalling by firms
Reputation, Brand names to
Third party differentiate product.
comparisons,
Which reports,
 Price Discrimination Through
Asymmetric Information
Charge a different price according to
willingness to pay.
Some consumers may falsely believe a
product is of a higher quality.
Own label product.
 Tourist Trap Model
Pure competitive market:
All firms charge the same price.
A higher price results in zero demand.
Imperfect information in a competitive market.
Know the prices charged by shops but not specific price
charged by a specific shop.
Competitive price is p*.
Firm can charge p*+e.
e is less than cost of finding another shop.
Monopoly price in a tourist trap
Suppose all firms charge p*+e
Same reasoning implies all firms can raise price to p*+2e
This argument can continue to be applied until all firms
charge the monopoly price.
At this price further price increases result in a loss of profit.
In a market where finding prices is costly the equilibrium
price is the monopoly price.
If firms are allowed to advertise prices so that search costs
disappear the competitive price results.
 Employee safety with asymmetric
information
Employees in safer industries pay lower wages than
in unsafe.
Safety statistics are reported at industry levels, not
the firm level.
Lying to a potential employer?
 Education as a signal
Low ability people will not graduate.
Have to accept lower unskilled wage.
High ability people will go to college if difference
between skilled and unskilled wage exceeds cost
of education
Two equilibrea are possible
Pooling
When costs of education exceed the wage differential and
everyone is paid the same.
Seperating
When it pays to go to college.
Pooling and separating equilibrea
Unique or multiple equilibrea
c, Cost per diploma, $

Pooling equilibrium

20,000 c = wh wl

Pooling or separating equilibrium

x y
15,000

z
5,000 c
q = 1
wh wl
Separating equilibrium

0 1 1 1

4 2 q, Share of high-ability workers