Applied microeconomics
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Applied Microeconomics Asymmetric Information Outline Adverse selection Signaling Screening Readings Kreps: Chapter 18 Perloff: Chapter 19 Zandt: 12C Introduction What happens when some market participants know more than others? Examples:

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Applied microeconomics l.jpg

Applied Microeconomics

Asymmetric Information

Outline l.jpg

  • Adverse selection

  • Signaling

  • Screening

Readings l.jpg

  • Kreps: Chapter 18

  • Perloff: Chapter 19

  • Zandt: 12C

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  • What happens when some market participants know more than others?

  • Examples:

    • Sellers who know more about the quality of their product than prospective buyers

    • Workers who know more about their skills than prospective employees

    • Insiders who know more about a firm’s value than outside shareholders

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Types of Information Asymmetries

  • Unobservable characteristics: adverse selection

  • Unobservable actions: moral hazard

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Adverse Selection

  • In 1994, the average car depreciated 37% in its first year and 13% more under the second year

  • 35% of all cars were sold through car dealerships, typically offering warranties

  • The average price of a used car in 1994 was about $11,500, but the average private-sale price for a used car was about $2,000 less

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Adverse Selection

  • “Adverse selection occurs when an informed individual’s trading decision depends on her unobservable characteristics in a manner that adversely affects the uninformed agents in the market.”

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Example: Market for “Lemons”

  • Suppose two types of cars – good quality in share g and bad quality “lemons” in share 1-g

  • Finite number of sellers with reservation prices 1800 Euros for good cars and 800 Euros for bad cars

  • Numerous risk-neutral buyers with reservation prices 2000 Euros for good cars and 1000 Euros for lemons

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Example: Market for “Lemons”

  • If quality observable to buyers, then both types of cars would be traded at prices 2000 and 1000 respectively

  • If quality unobservable to buyers, and both cars are offered, then buyers are prepared to pay 2000g+(1-g)1000=1000+1000g

  • Sellers of good cars are willing to sell when 1000+1000g≥1800, or in other words if g≥80%

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Example: Market for “Lemons”

  • What if the share of good cars is less than 80%?

  • Then only bad cars are offered, and, the buyers anticipating this, offer 1000

  • Good cars are thus driven out of the market!

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Example: Market for “Lemons”


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  • Screening

  • Signaling

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  • Remember how firms practicing second-degree price discrimination could choose the quality and tariffs of goods such that different types self-select different goods/bundles?

  • In the same manner a firm with no information can screen possible counterparties

  • “Screening refers to activities undertaken by the party without private information in order to separate different types of the informed party along some dimension”

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  • In markets with adverse selection, an informed party of high quality may overcome the adverse selection problem by signaling his type

  • However, the cost of the signal must be such that:

    • It is not in the interest of an informed party of low quality to imitate and the send the same signal

    • It is not too expensive for the high type to signal

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  • High-ability workers can signal their ability to firms by acquiring a certain level of education

  • Entrepreneurs with profitable projects can signal the profitability of the project to VC:s by offering holding on to an equity stake in the venture

  • Car dealers can signal the quality of a used car by offering a warranty

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Spence’s Model of Labor Market Signaling

  • Consider a competitive labor market with workers of marginal productivity L in share q, and workers of marginal productivity H>L in share 1-q

  • Allworkers are assumed to have a reservation wage of 0

  • Firms want to hire workers to perform a task, but ability is not observable to them

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Spence’s Model of Labor Market Signaling

  • With symmetric information low productivity workers would be paid a wage of wL=L and high productivity workers a wage of wH=H

  • With asymmetric information and no way for employers to separate types there would be an equilibrium where all workers received a wage of w=qL+(1-q)H

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Separating Equilibrium

  • Suppose now that high productivity workers can get a degree attending school at a cost (psychic and economic) c and that low productivity workers cannot graduate from school

  • Assume for simplicity that the productivity of the worker is not affected by the education

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Pooling Equilbria

  • If H-c>qL+(1-q)H, or equivalently q(H-L)>c, only a separating equilibrium, where only high-productivity workers go to school and firms rightly believe that only graduates are of high productivity, is possible

  • If on the other hand H-c<L, or equivalently H-L<c, then only a poolingequilibrium with a uniform wage for everyone is possible

  • If q(H-L)≤c≤H-L, then both types of equilibria are possible

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  • If education does not raise productivity, then signaling is often socially inefficient

    • In our example, output and total wages are the same with and without signaling, but education is costly

    • Low productivity workers are definitely worse off

    • If w>H-c>L, then high-ability workers are also worse off

  • Reason is that private returns to education exceeds net social returns

  • Education can be socially efficient when it raises total output (lemons market) or productivity

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  • Embarrassment of riches

    • Hard to make predictions:

      • Not only both separating and pooling equilibria

      • Also separating equilibria with different costs of education for high-productivity workers

    • Some equilibria Pareto dominate others

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  • Self-confirming equilibria are possible:

    • Suppose employers believe that in addition to education some observable and completely independent characteristic such as sex or skin color is a signal of productivity

    • Even if the share of low- and high-productivity workers is the same among men and women, we could have a separating equilibrium among male workers and a pooling equilibrium among female workers

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  • Adverse selection occurs when asymmetric information about characteristics affect some party adversely

  • Screening is when the uninformed party designs contracts to elicit information about the characteristics of the informed party

  • Signaling is when the informed party takes a costly action in order to convey information about his type to the uninformed party