Asymmetric Information Perloff Chapter 19 Asymmetric Information When

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Asymmetric Information Perloff Chapter 19

Asymmetric Information Perloff Chapter 19

Asymmetric Information • When two parties to a transaction have different information. • Adverse

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 drives faster.

Equalising information • Screening – Obtaining information about hidden characteristics. – Insurance. – Costly.

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 1, 500 1, 000 (b) Market for Good

Market for lemons and good cars 1, 500 1, 000 (b) Market for Good Cars SL f e D* Price of a good car, $ Price of a lemon, $ (a) Market for Lemons E 2, 000 1, 750 S 2 1, 500 1, 250 DL F DG D* S 1 750 0 1, 000 Lemons per year 0 1, 000 Good cars per year

Preventing the occurrence of lemon markets • Laws – Product liability laws, • Consumer

Preventing the occurrence of lemon markets • Laws – Product liability laws, • Consumer screening – The use of a mechanic, – Reputation, • Third party comparisons, – ‘Which’ reports, • Standards and certification, – Kite marks, • Signalling by firms – Brand names to differentiate product.

Price Discrimination Through Asymmetric Information • Charge a different price according to willingness to

Price Discrimination Through Asymmetric Information • Charge a different price according to willingness to pay. • Some consumer’s 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.

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

Monopoly price in a ‘tourist trap’ • Suppose all firms charge p*+e – Same reasoning implies all firms can raise price to p*+2 e • 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

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?

Lying to a potential employer?

Education as a signal • Low ability people will not graduate. – Have to

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

Pooling and separating equilibrea

c, Cost per diploma, $ Unique or multiple equilibrea Pooling equilibrium c = wh

c, Cost per diploma, $ Unique or multiple equilibrea Pooling equilibrium c = wh – wl 20, 000 Pooling or separating equilibrium 15, 000 x y z 5, 000 Separating equilibrium 0 1 – 4 1 – 2 c—— q = 1 – —— wh – wl 1 q, Share of high-ability workers