chapter 21 asymmetric information copyright © 2014 mcgraw-hill education. all rights reserved. no...
TRANSCRIPT
chapter 21
Asymmetric Information
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
21-2
Learning Objectives
• Understand how adverse selection impacts markets.• Explain the concepts of signaling and screening.• Understand the effects of competitive signaling and
screening on resource allocation, and discuss the implications for government policy.
• Explain how moral hazard can impact a trading relationship.
• Describe how an incentive scheme can create incentives to take favorable actions, and some of the potential problems with providing incentives.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
21-3
Overview
• Informational asymmetries occur when one party to a transaction is less well-informed than another
• When the uninformed party may be reluctant to trade, adverse selection may cause markets to perform poorly
• The informed individual may take a costly action (signaling) to influence others’ beliefs, or the uninformed party may present an informed party with a collection of options (screening), counting on the choices of that party to reveal what she knows
• Moral hazard occurs when the informed party takes actions that a trading partner cannot observe, and that affect the benefits the partner receives from the trade
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21-4
Adverse Selection and Lemons
• In a used-car market, sellers want to sell bad cars (“lemons”) and keep good ones
• Thus, buyers of used cars must be wary of quality, and that consideration drives the price of a used car down and reduces the number of good cars owners are willing to sell
• In some cases, adverse selection can drive good cars from the market completely
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Adverse Selection in a Labor Market
• Consider the labor market for entry-level software programmers in Palo Alto, California
• Suppose that each worker has either high or low ability
• A high-ability worker generates $12,000 of profit per month
• A low-ability worker generates only $6,000
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Demand and Supply for Software Programmers
• When a worker’s ability is observable, high- and low-ability workers receive different wages
• In a competitive labor market, employers hire 400 low-ability workers at a monthly wage of $6,000 and 500 high-ability workers at $12,000
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Ability is Not Observable by Employers
• At every wage above $2,000, the number of low-ability workers willing to work is double the number of high-ability workers
• On average, a worker generates a profit of $8,000 per month
• The equilibrium wage is $8,000 and 900 workers are hired (300 high-ability and 600 low-ability)
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21-8
Market Unraveling
• Market unraveling occurs in settings with adverse selection when the presence of unattractive trading partners drives attractive trading partners out of the market by altering the prices at which they can trade
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21-9
Market Unraveling Due to Adverse Selection
Only low-ability workers
Mix of low- and high-ability workers
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21-10
Responses to Adverse Selection
• When adverse selection leads to market failures, governments and private organizations often respond to reduce potential economic losses
• Examples– Government-mandated minimum quality standards,
which reduce the asymmetry of information– Government-provided insurance (social insurance)– On eBay, past purchasers can post reviews of a
seller’s performance
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21-11
Signaling
• Signaling occurs when someone takes a costly action to influence others’ beliefs
• Signaling offers a partial solution to problems that arise from adverse selection– Example: many dealers sell used cars with
warranties. Offering a warranty serves as a signal that the seller has a high-quality car.
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21-12
A Model of Educational Attainment
The greater the worker’s ability, the smaller is the wage increase required to compensate for an increase in education. That pattern reflects an assumption that education is easier and/or more pleasant for those with greater academic talent.
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21-13
Market Equilibria with Asymmetric Information
• In a separating equilibrium, people with different information choose different alternatives
• In a pooling equilibrium, people with different information choose the same alternative
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21-14
Separating Equilibrium
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• Low-ability workers receive the minimum amount of education required by law (10 years), while high-ability workers stay in school longer ( years)
• Firms pay $50 per hour to those with years of schooling, and $20 per hour to those with 10 years of schooling
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Screening
• Screening occurs when a less-informed party presents an informed party with a collection of options, and counts on the choices of that party to reveal what she knows
• Examples– Insurance companies allow clients to customize policies
in a number of ways (e.g., size of deductible)– An employer who wants to hire a certain type of worker
may design the position in a way that attracts applicants with the desired characteristics and repels others
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21-16
A Model of Workplace Responsibilities
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21-17
When Employers Know Workers’ Abilities
$10 per task
$5 per task
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21-18
Market Equilibria with Asymmetric Information
• If an employer offers workers a choice between two different rates of compensation per task, one high and one low, and places no requirements on the number of tasks performed, all workers will choose the higher rate of compensation.
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Voluntary Sorting by Workers
• Two types of jobs– Perform 60 tasks at $480
a day (rate of $8 per task)– Perform 20 tasks at $120
a day (rate of $6 per task)• Workers self-select into
different jobs– High-ability workers
choose point C– Low-ability workers
choose point D
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21-20
A Possible Role for the Government
• In the screening equilibrium of a competitive insurance market, high-risk individuals get full coverage
• Low-risk individuals end up accepting large deductibles and high co-payments
• Because they are risk-averse, low-risk individuals would like to buy more insurance
• By compelling participation in a social insurance program, the government can typically achieve a Pareto improvement
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21-21
Moral Hazard
• Moral hazard is present when one party to a transaction takes actions that a trading partner cannot observe, and that affect the benefits the partner receives from the trade
• The uninformed party wants to ensure that her trading partner takes actions that promote her interests
• An incentive scheme is a contract or compensation policy that ties rewards or punishments to performance, designed in a manner to induce desirable behavior
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21-22
Efficiency and Incentive Pay
Benefits to employer
Salesperson’s cost of effort
Efficient outcome
Efficient outcome
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21-23
Incentive Pay and Effort
$1,200 per week plus a bonus of $500 for each car the salesperson sells (assuming each hour of high effort generates a 4% chance of selling a car.)
Lower than efficient outcome
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Efficient Incentive Contract
• Base pay of $600 plus a bonus of $1,000 for each car sold by salesperson
• Efficient outcome
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21-25
Costs of Incentives
• Incentive schemes may transfer part or all of the risk and uncertainty to the risk-averse individual
• Incentive pay induces employees to concentrate only on measured aspects of performance
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21-26
Review
• Adverse selection is present if an informed individual is more willing to trade when trading is less advantageous for an uninformed trading partner
• Signaling occurs when an informed individual undertakes a costly activity to influence others’ beliefs
• Screening occurs when the less-informed party presents the informed party with a collection of options, and counts on the choices of the informed party to reveal what she knows
• With moral hazard, the informed party takes action that a trading partner cannot observe, and that affects the benefits the partner receives from the trade
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