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Introductory to Microeconomics 1st edition. Chapter 17. Asymmetric information. Wyn Morgan. Introduction . In many transactions, the people involved have different amounts of information. Introduction.

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slide1

Introductory to Microeconomics

1st edition

Chapter 17

Asymmetric information

Wyn Morgan

introduction
Introduction
  • In many transactions, the people involved have different amounts of information.
introduction1
Introduction
  • As well as many other situations in which one side of deal knows something that the other does not, e.g. buying used car or when a firm hires a new employee!
introduction2
Introduction
  • As well as many other situations in which one side of deal knows something that the other does not, e.g. buying used car or when a firm hires a new employee!
  • Where one side know more than the other we have ‘asymmetric information’.
asymmetric information
Asymmetric information
  • The existence of asymmetric gives rise to:
      • Hidden characteristics
      • Hidden actions
hidden characteristics
Hidden characteristics
  • Whenever one side of the a transactions knows something about itself that the other side does not know, we have ‘hidden characteristics’.
hidden actions
Hidden actions
  • Whenever one die of the an economic relationship takes actions that the other side cannot observe is a situation of ‘hidden cost’.
signalling and screening
Signalling and screening
  • We next examine the effects of hidden characteristics on the operation and performance of markets.
another look at discrimination
Another look at discrimination
  • Typically consumers know how much they are willing to pay for a good, but the firm selling to them does not!
another look at discrimination1
Another look at discrimination
  • Typically consumers know how much they are willing to pay for a good, but the firm selling to them does not!
  • The firm would like to know what customers are prepared to pay:
another look at discrimination2
Another look at discrimination
  • Typically consumers know how much they are willing to pay for a good, but the firm selling to them does not!
  • The firm would like to know what customers are prepared to pay:
      • Via signals and screening
normative analysis of second degree price discrimination
Normative analysis of second degree price discrimination
  • When possible, second degree price discrimination can raise the sellers profits.
normative analysis of second degree price discrimination1
Normative analysis of second degree price discrimination
  • When possible, second degree price discrimination can raise the sellers profits.
  • The question here is what happens to total surplus when price changes?
normative analysis of second degree price discrimination2
Normative analysis of second degree price discrimination
  • When possible, second degree price discrimination can raise the sellers profits.
  • The question here is what happens to total surplus when price changes?
normative analysis of second degree price discrimination3
Normative analysis of second degree price discrimination
  • When possible, second degree price discrimination can raise the sellers profits.
  • The question here is what happens to total surplus when price changes?
  • This gives rise to:
      • Allocate efficiency
      • Welfare effects
competitive market signalling
Competitive market signalling
  • Under second degree price discrimination, a firm with market power uses a signal to sort consumers and discriminate among them!
competitive market signalling1
Competitive market signalling
  • Under second degree price discrimination, a firm with market power uses a signal to sort consumers and discriminate among them!
  • The use of signals also can be an important phenomenon in competitive markets.
competitive market signalling example
Competitive market signalling - example
  • The example considered here is one low ability and high ability workers (Spence 1974)
competitive market signalling example1
Competitive market signalling - example
  • The example considered here is one low ability and high ability workers (Spence 1974)
  • The question that arises here is:
      • Why consumer education?
competitive market signalling example2
Competitive market signalling - example
  • The answer must be that there are some offsetting benefits from consuming education despite the initial costs involved!
what about the low ability worker
What about the low ability worker?
  • By assumption, the disutility of going to university is higher for these workers.
what about the low ability worker1
What about the low ability worker?
  • By assumption, the disutility of going to university is higher for these workers.
  • Therefore, the low ability person needs greater compensation for getting through an additional year of education than for the high ability person, ceteris paribus.
normative analysis of education as a signal
Normative analysis of education as a signal
  • The question here how does the use of education as a signal affect the surplus of different types of workers?
normative analysis of education as a signal1
Normative analysis of education as a signal
  • The question here how does the use of education as a signal affect the surplus of different types of workers?
  • Note that high ability worker’s wages rise because of more schooling.
normative analysis of education as a signal2
Normative analysis of education as a signal
  • The question here how does the use of education as a signal affect the surplus of different types of workers?
  • Note that high ability worker’s wages rise because of more schooling.
  • And that low ability workers are low because of less schooling.
id education really just a signal
Id education really just a signal?
  • The conclusion here is that education as a signal are very disturbing to many people and important to consider:
id education really just a signal1
Id education really just a signal?
  • The conclusion here is that education as a signal are very disturbing to many people and important to consider:
    • Wages rise with more schooling
id education really just a signal2
Id education really just a signal?
  • The conclusion here is that education as a signal are very disturbing to many people and important to consider:
    • Wages rise with more schooling
    • The model may lead to too a special outcome to lead to any real outcome
adverse selection
Adverse selection
  • In some markets, the very fact that the informed party wants to deal with the uninformed party can serve as signal!
more on insurance markets
More on insurance markets!
  • The question, here, is how much insurance to buy?
  • What if the probability of the negative outcome being observes increases but this is not communicated to the insurance company – what happens?
more on insurance markets1
More on insurance markets!
  • The analysis can be done on two fronts:
      • The full information equilibrium
      • Partial information available
more on insurance markets2
More on insurance markets!
  • The analysis can be done on two fronts:
      • The full information equilibrium
      • Partial information available
      • The asymmetric information equilibrium
asymmetric information equilibrium
Asymmetric information equilibrium
  • Here the situation is that the person taking out the insurance does not inform the insurance company of the full facts!
asymmetric information equilibrium1
Asymmetric information equilibrium
  • When tastes differ such that an individual is prepared to drop out of the market what happens then?
market responses to adverse selection
Market responses to adverse selection
  • We have seen thus far that asymmetric information can be adverse consequences for efficiency.
market responses to adverse selection1
Market responses to adverse selection
  • We have seen thus far that asymmetric information can be adverse consequences for efficiency.
  • Examples here would be:
      • Insurance and testing for AIDS
      • Group health plans
      • Targeted insurance rates
other markets in which adverse selection is important
Other markets in which adverse selection is important
  • Adverse selection is not just confined to insurance markets. It can be applied to:
      • Labour markets
      • The market for human blood (Politis, 2000)
government responses to hidden characteristics
Government responses to hidden characteristics
  • Hidden characteristics may fall short of achieving efficient outcomes if everyone were to be fully informed.
government responses to hidden characteristics1
Government responses to hidden characteristics
  • Hidden characteristics may fall short of achieving efficient outcomes if everyone were to be fully informed.
  • This raises the possibility that government intervention could intervene and improve matters!
government responses to hidden characteristics2
Government responses to hidden characteristics
  • Example of this is:
      • Compulsory public pension programmes
government responses to hidden characteristics3
Government responses to hidden characteristics
  • Example of this is:
      • Compulsory public pension programmes
      • Informational disseminating policies
hidden actions1
Hidden actions
  • Since by its very nature where information is limited we have hidden actions.
hidden actions2
Hidden actions
  • Since by its very nature where information is limited we have hidden actions.
  • The question how can these hidden actions be revealed?
hidden actions3
Hidden actions
  • Since by its very nature where information is limited we have hidden actions.
  • The question how can these hidden actions be revealed?

Answer –principal agent relationship!

hidden actions4
Hidden actions

‘To get individuals to take the right action, the contract has to give the individual the right incentives’

moral hazard in insurance markets
Moral hazard in insurance markets
  • The problem of hidden actions is that individual’s decisions are distorted!
moral hazard in insurance markets1
Moral hazard in insurance markets
  • The problem of hidden actions is that individual’s decisions are distorted!
  • Examples when moral hazard is present:
      • Fire prevention in the absence of insurance
moral hazard and insurance example
Moral hazard and insurance - example
  • The effect of moral hazard is most dramatic when the homeowner over-insures to get more money for the property if it burns down than by selling it on the open market
efficiency effects of moral hazard
Efficiency effects of moral hazard
  • Sometimes people damage their own property to claim the insurance payment!
efficiency effects of moral hazard1
Efficiency effects of moral hazard
  • Sometimes people damage their own property to claim the insurance payment!
  • Clearly burning the property down to collect on the insurance is wasteful and inefficient, isn’t it?
efficiency effects of moral hazard2
Efficiency effects of moral hazard
  • Not really as it reduces the ‘care levels’!
co insurance and deductibles
Co-insurance and deductibles
  • The problem of moral hazard arises because insurance reduces the incentives for care.
co insurance and deductibles1
Co-insurance and deductibles
  • The problem of moral hazard arises because insurance reduces the incentives for care.
  • One way mitigate this problem is to reduce the level of insurance and require the policy holder to bear some of the costs of a claim.
co insurance and deductibles2
Co-insurance and deductibles
  • Many insurance policies have what is known as ‘co-insurance’.
co insurance and deductibles3
Co-insurance and deductibles
  • Many insurance policies have what is known as ‘co-insurance’.
  • Another example of making the policy holder bear some of the risk is to have ‘an excess’ or ‘deductible’.
employer employee relationships
Employer-employee relationships
  • Problem of moral hazard are important in many other employer-employee relationship.
employer employee relationships1
Employer-employee relationships
  • Problem of moral hazard are important in many other employer-employee relationship.
  • The question is how does the manager know that his workers are all working efficiently and not shirking?
observable shirking1
Observable shirking
  • If performance cannot be observed what can management do?
observable shirking2
Observable shirking
  • If performance cannot be observed what can management do?
  • Management could consider:
      • A flat salary
      • Performance based compensation
two puzzles
Two puzzles
  • The theory thus far suggest that performance based schemes are superior to flat salaries!
two puzzles1
Two puzzles
  • Now, since managers are on fixed salaries and not paid the pure residual we have the following questions:
      • Why do people paid on salary do ant work?
      • If residual claimant contracts have such good incentive properties, why are not all contracts of this form?
moral hazard in product markets
Moral hazard in product markets
  • Sometimes you pay for something without knowing exactly what you are getting for your money!
moral hazard in product markets1
Moral hazard in product markets
  • Sometimes you pay for something without knowing exactly what you are getting for your money!
  • There is thus the potential for moral hazard problems because a firm can reduce its costs by lowering its product’s quality,which lowers consumer welfare, ceteris paribus.