Microeconomics

Eighth Edition

Chapter 19
Asymmetric
Information

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Learning Objectives
19.1 Adverse Selection.
19.2 Reducing Adverse Selection.
19.3 Price Discrimination Due to False Beliefs About
Quality.
19.4 Market Power from Price Ignorance.
19.5 Problems Arising from Ignorance When Hiring.

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Asymmetric Information
• Symmetric information - Everyone is equally
knowledgeable or equally ignorant about prices,
product quality, and other factors relevant to a
transaction.
• Asymmetric information - One party to a transaction
has relevant information that another party lacks.

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Types of Asymmetric Information
Two types of asymmetric information:
• Hidden characteristics - an attribute of a person or thing
that is known to one party but unknown to others.
• Hidden actions - an act by one party to a transaction that
is not observed by the other party.

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Opportunistic Behavior
• Opportunistic behavior - one party takes economic
advantage of another when circumstances permit.
• Such opportunistic behavior due to asymmetric
information leads to market failures, and destroys
many desirable properties of competitive markets.

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Problems Due to Asymmetric
Information
• Adverse selection - occurs when one party to a
transaction possesses information about a hidden
characteristic that is unknown to other parties and
takes economic advantage of this information.
• Moral hazard - an informed party takes an action that
the other party cannot observe and that harms the
less-informed party.

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Adverse Selection
• One of the most important problems associated with
adverse selection is that consumers may not make
purchases to avoid being exploited by better-informed
sellers.
• As a result, not all desirable transactions occur, and
potential consumer and producer surplus is lost.

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Adverse Selection in Insurance
Markets
• Were a health insurance company to provide fair
insurance by charging everyone a rate for insurance
equal to the average cost of health care for the entire
population, the company would lose money due to
adverse selection.
• Adverse selection results in an inefficient market
outcome because the sum of producer and consumer
surplus is not maximized.
• The loss of potential surplus occurs because some
potentially beneficial sales of insurance to relatively
healthy individuals do not occur.
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Products of Unknown Quality (1 of 3)
• Adverse selection often arises because sellers of a
product have better information about the product’s
quality—a hidden characteristic—than do buyers.
• If buyers have the same information as sellers, no
adverse selection problem arises.
• However, when sellers have more information than
buyers, adverse selection may drive high-quality
products out of the market.

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Products of Unknown Quality (2 of 3)
• Cars that appear to be identical on the outside often
differ substantially in the number of repairs they will
need.
– Some cars —lemons— have a variety of insidious
problems that become apparent to the owner only after
the car has been driven for a while.
– The seller of a used car knows from experience
whether the car is a lemon.
– We assume that the seller cannot alter the quality of
the used car.

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Products of Unknown Quality (3 of 3)
• Suppose that there are many potential buyers for
used cars. All are willing to pay $4,000 for a lemon
and $8,000 for a good used car.
• 1,000 owners of lemons and 1,000 owners of good
cars are willing to sell.
– The reservation price of owners of lemons—the lowest
price at which they will sell their cars—is $3,000.
• The reservation price of owners of high-quality used
cars is v, which is less than $8,000.

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Figure 19.1 Markets for Lemons and
Good Cars

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Market Equilibrium with Symmetric
Information (1 of 2)
• If both sellers and buyers know the quality of all the
used cars before any sales take place, all the cars are
sold, and good cars sell for more than lemons.
This market is efficient because the goods go to the
people who value them the most.

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Market Equilibrium with Symmetric
Information (2 of 2)
• The amount of information they have affects the price at
which the cars sell.
– If no one can tell a lemon from a good car at the time of
purchase, both types of cars sell for the same price.
Sellers of good-quality cars are implicitly subsidizing
sellers of lemons.

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Market Equilibrium with Asymmetric
Information (1 of 6)
• If sellers know the quality but buyers do not, this
market may be inefficient:
– The better-quality cars may not be sold even though
buyers value good cars more than sellers do.
– The equilibrium in this market depends on whether the
value that the owners of good cars place on their cars,
v, is greater or less than the expected value of buyers,
$6,000.

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Market Equilibrium with Asymmetric
Information (2 of 6)
• There are two possible equilibria:
– All cars sell at the average price.
– Only lemons sell for a price equal to the value that
buyers place on lemons.

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Market Equilibrium with Asymmetric
Information (3 of 6)
• Initially, we assume that the sellers of good cars value
their car at v = $5,000, which is less than the buyers’
expected value of the cars, so that transactions occur.
Thus, all cars sell at the same price.

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Market Equilibrium with Asymmetric
Information (4 of 6)
• Consequently, asymmetric information does not cause
an efficiency problem, but it does have equity
implications.
– Sellers of lemons benefit and sellers of good cars
suffer from consumers’ inability to distinguish quality.
– Consumers who buy the good cars get a bargain, and
buyers of lemons are left with a sour taste in their
mouths.

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Market Equilibrium with Asymmetric
Information (5 of 6)
• Now suppose that the sellers of good cars place a
value of v = $7,000 on their cars and thus are
unwilling to sell them for $6,000.
– As a result, the lemons drive good cars out of the
market.
– Buyers realize that, at any price less than $7,000, they
can buy only lemons.
– Consequently, in equilibrium, the 1,000 lemons sell for
the expected (and actual) price of $4,000, and no good
cars change hands.

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Market Equilibrium with Asymmetric
Information (6 of 6)
• This equilibrium is inefficient because high-quality
cars remain in the hands of people who value them
less than potential buyers do.

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Solved Problem 19.1
• Suppose that everyone in our used car example is risk
neutral, and potential car buyers value lemons at
$4,000 and good used cars at $8,000. The reservation
price of lemon owners is $3,000 and the reservation
price of owners of high-quality used cars is $7,000.
The share of current owners who have lemons is θ (in
our previous example, the share was   1 ).
2
For what values of θ do all the potential sellers sell
their used cars? Describe the equilibrium.

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Solved Problem 19.1: Answer
1. Determine how much buyers are willing to pay if all
cars are sold. Because buyers are risk neutral, if
they believe that the probability of getting a lemon is,
the most they are willing to pay for a car of unknown
quality is the average price.
2. Solve for the values of such that all the cars are
sold, and describe the equilibrium. All owners will sell
if the market price equals or exceeds the reservation
price of good car owners, $7,000.

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Varying Quality with Asymmetric
Information
• This unwillingness to produce high-quality products is
due to an externality: A firm does not completely
capture the benefits from raising the quality of its
product.
• The social value of raising the quality, as reflected by
the increased revenues shared by all firms, is greater
than the private value, which is only the higher
revenue received by the firm with the good product.

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Solved Problem 19.2
• It costs $10 to produce a low-quality wallet and $20 to
produce a high-quality wallet. Consumers cannot
distinguish between the products before purchase,
they do not make repeat purchases, and they value
the wallets at the cost of production. The five firms in
the market produce 100 wallets each. Each firm
produces only high-quality or only low-quality wallets.
Consumers pay the expected value of a wallet. Do
any of the firms produce high-quality wallets?

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Solved Problem 19.2: Answer
1. Calculate the expected value of wallet.
2. Show that it does not pay for one firm to make high-
quality wallets if the other firms make low-quality
wallets due to asymmetric information.
Due to asymmetric information, the firms do not
produce high-quality goods even though consumers are
willing to pay for the extra quality.

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Reducing Adverse Selection
• Because adverse selection results from one party
exploiting asymmetric information about a hidden
characteristic, the two main methods for solving
adverse selection problems are to:
1. Restrict the ability of the informed party to take
advantage of hidden information.
2. Equalize information among the parties.

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Equalizing Information (1 of 2)
• Three methods for reducing informational
asymmetries are:
1. An uninformed party can use screening.
2. An informed party can use signaling.
3. A third party not directly involved in the transaction
may collect information and sell it or give it to the
uninformed party.

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Equalizing Information (2 of 2)
• Screening - an action taken by an uninformed person
to determine the information possessed by informed
people.
• Signaling - an action taken by an informed person to
send information to an uninformed person.

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Third-Party Information
• Standard - a metric or scale for evaluating the quality
of a particular product.
• Certification - a report that a particular product meets
or exceeds a given standard.

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Restricting Opportunistic Behavior
• Disclosure Requirements
• Product Liability Laws
• Universal Coverage

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Market Power from Price
Ignorance (1 of 2)
• Suppose that many stores in a town sell the same
good.
– If consumers have full information about prices, all
stores charge the full-information competitive price, p*.
– If one store were to raise its price above p*, the store
would lose all its business.
– Each store faces a residual demand curve that is
horizontal at the going market price and has no market
power.

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Market Power from Price
Ignorance (2 of 2)
• If consumers have limited information about the price
that firms charge for a product, one store can charge
more than others and not lose all its customers.
– Customers who do not know that the product is
available for less elsewhere keep buying from the high-
price store.
– Thus, each store faces a downward-sloping residual
demand curve and has some market power.

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Tourist-Trap Model (1 of 3)
• You arrive in a small town near the site of the discovery of
gold in California. Souvenir shops crowd the street.
Wandering by one of these stores, you see that it sells the
town’s distinctive snowy: a plastic ball filled with water and
imitation snow featuring a model of the Donner Party. You
instantly decide that you must buy at least one of these
tasteful mementos—perhaps more if the price is low
enough. Your bus will leave very soon, so you can’t check
the price at each shop to find the lowest price. Moreover,
determining which shop has the lowest price won’t be useful
to you in the future because you do not intend to return
anytime soon.

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Tourist-Trap Model (2 of 3)
• Let’s assume that you and other tourists have a
guidebook that reports how many souvenir shops
charge each possible price for the snowy, but the
guidebook does not state the price at any particular
shop. There are many tourists in your position, each
with an identical demand function.

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Tourist-Trap Model (3 of 3)
• It costs each tourist c in time and expenses to visit a
shop to check the price or buy a snowy.
– Thus, if the price is p, the cost of buying a snowy at the
first shop you visit is p + c.
– If you go to two souvenir shops before buying at the
second shop, the cost of the snowy is p + 2c.

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When Price Is Not Competitive
• Will all souvenir shops charge the same price?
– If so, what price will they charge?
• If all other shops charge p a firm can profitably charge
p1  p   ,
‒ Where  a small positive number, is the shop’s
price markup.
• If consumers have limited information about price,
an equilibrium in which all firms charge the full-
information, competitive price is impossible.
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Monopoly Price
• Can there be an equilibrium in which all stores charge
the same price and that price is higher than the
competitive price?
– The monopoly price may be an equilibrium price.
‒ When consumers have asymmetric information and
when search costs and the number of firms are large,
the only possible single-price equilibrium is at the
monopoly price.

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Solved Problem 19.3
• Initially, there are many souvenir shops, each of which
charges pm (because consumers do not know the
shops’ prices), and buyers’ search costs are c. If the
government pays for half of consumers’ search costs,
can there be a single-price equilibrium at a price less
than pm possible?

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Solved Problem 19.3: Answer
• Show that the argument we used to reject a single-
price equilibrium at any price except the monopoly
price did not depend on the size of the search cost.

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Problems Arising from Ignorance
When Hiring
• Asymmetric information is frequently a problem in
labor markets.
• Prospective employees may have less information
about working conditions than firms do.
• Firms may have less information about potential
employees’ abilities than the workers do.

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Cheap Talk (1 of 3)
• When an informed person voluntarily provides
information to an uninformed person, the informed
person engages in:
– Cheap talk - unsubstantiated claims or statements.

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Cheap Talk (2 of 3)
• Suppose that a firm plans to hire Cyndi to do one of
two jobs.
– The demanding job requires someone with high ability.
– The undemanding job can be done better by someone
of low ability because the job bores more able people,
who then perform poorly.

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Table 19.1(a) Employee-Employer
Payoffs
(a) When Cheap Talk Works

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Table 19.1(b) Employee-Employer
Payoffs
(b) When Cheap Talk Fails

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Cheap Talk (3 of 3)
• If it gives her the undemanding job, the firm’s
expected payoff is:

1  1 
1 
2  2 4  2.5
   

• If it gives her the demanding job, the firm’s expected

1  1 
2 2    2 1 1.5
   

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Education as a Signal (1 of 4)
• If high-ability people are more likely to go to college
than low-ability people, schooling signals ability to
employers.
• Extreme assumptions that
– Graduating from an appropriate school serves as the
signal.
– Schooling provides no training that is useful to firms.

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Education as a Signal (2 of 4)
• High-ability workers are θ share of the workforce, and
low-ability workers are 1 − θ share.
• The value of output that a high-ability worker produces
for a firm is worth wh, and that of a low-ability worker is
wl (over their careers).

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Education as a Signal (3 of 4)
• Pooling equilibrium - an equilibrium in which
dissimilar people are treated (paid) alike or behave
alike.
• Employers pay all workers the average wage:

w  w h  1   w l

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Education as a Signal (4 of 4)
• We assume that
– High-ability individuals can get a degree by spending c
to attend a school.
– Low-ability people cannot graduate from the school.

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Separating Equilibrium (1 of 2)
• Separating equilibrium - an equilibrium in which one
type of people takes actions (such as sending a
signal) that allows them to be differentiated from other
types of people.

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Separating Equilibrium (2 of 2)
• In a separating equilibrium,
– high-ability people pay c to get a degree and are
employed at a wage of wh,
– while low-ability individuals do not get a degree and
work for a wage of wl.

• A high-ability person chooses to get a degree if

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Pooling Equilibrium
• In a pooling equilibrium, all workers are paid the
average wage.
• It does not pay for the high-ability person to graduate
if the benefit from graduating, the extra pay is less
than the cost of schooling:

wh  w  c

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Solved Problem 19.4
• For what values of θ is a pooling equilibrium possible
in general? In particular, if c = $15,000, wh = $40,000,
and wl = $20,000, for what values of θ is a pooling
equilibrium possible?

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Solved Problem 19.4: Answer
1. Determine the values of θ for which it pays for a
high-ability person to go to school.
2. Solve for the possible values of θ for the specific
parameters.

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Unique or Multiple Equilibria
• Depending on differences in abilities, the cost of
schooling, and the share of high-ability workers, only
one type of equilibrium may be possible or both may
be possible.

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Figure 19.2 Pooling and Separating
Equilibria

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Efficiency (1 of 2)
• In our example of a separating equilibrium, high-ability
people get an otherwise useless education solely to
show that they differ from low-ability people.
• Signaling changes the distribution of wages:
– Instead of everyone getting the average wage, high-
ability workers receive more pay than low-ability
workers.

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Efficiency (2 of 2)
Total social output falls with signaling if signaling is
socially unproductive but may rise with signaling if
signaling also raises productivity or serves some
other desirable purpose.

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Screening in Hiring
• Firms screen prospective workers in many ways.
– Interviews and Tests
– Statistical Discrimination

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Figure 19.3 Statistical Discrimination

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Dying to Work

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