Asymmetric InformationSlide 2ExampleExample: Full InformationExample: Asymmetric InformationSlide 6Example: ObservationsProblemsAdverse Selection ExampleAdverse SelectionPooling EquilibriumExample 2ObservationsResponsesScreeningScreening ExampleScreening PoliciesEquilibriumScreening ObservationsSignalingLemon ModelPoolingSlide 23Inspecting LemonsSeparating LemonsObservations on SignalingGeneral CommentsMoral HazardExample: Hiring a CEOCEO RoadmapFull-Information CEOFull-Information ObservationsRisk-Neutral CEORisk-Neutral Contract RequirementsRisk-Neutral ContractsRisk-Averse CEORisk-Averse CEO AnalysisRisk-Averse CEO SolutionRisk-Averse Expected ProfitsRisk-Averse ObservationsIn GeneralAsymmetric InformationECON 370: Microeconomic TheorySummer 2004 – Rice UniversityStanley GilbertEcon 370 - Asymmetric Information 2Asymmetric Information•Up to now, we have assumed –Everyone is fully informed–Or equally uninformed•In many cases one party has economically relevant information that another party does not have•We term this “Asymmetric Information”•It can produce economic inefficiencyEcon 370 - Asymmetric Information 3Example•Suppose there are two types of umbrellas–Good and Bad•They cannot be distinguished until after they have been used–Bad umbrellas disintegrate after a little use•Umbrellas are valued as followsGoodBadValue toConsumerCost toProduce$11.50$14$11$8Econ 370 - Asymmetric Information 4Example: Full Information•Under full information, only good umbrellas would be sold•Since the cost to make a bad umbrella exceeds the benefit it providesGoodBadValue toConsumerCost toProduce$11.50$14$11$8Econ 370 - Asymmetric Information 5Example: Asymmetric Information•If umbrellas are good⅔–People are willing to pay:–⅔(14) + (8) = $12 per umbrella⅓–Which is greater than the cost to produce themGoodBadValue toConsumerCost toProduce$11.50$14$11$8Econ 370 - Asymmetric Information 6Example: Asymmetric Information•But firms make more money selling bad umbrellas•If all firms are small, they have incentive to switch to making bad umbrellas•Once ⅔ of firms make bad umbrellas:–People are willing to pay ⅓(14) + ⅔(8) = $10–Which is less than it costs to make any umbrellaGoodBadValue toConsumerCost toProduce$11.50$14$11$8Econ 370 - Asymmetric Information 7Example: Observations•Under full information we have the efficient result–Total Surplus = $14 – 11.50 = $2.50 per umbrella•Under Asymmetric information the market collapses–Total surplus = 0Econ 370 - Asymmetric Information 8Problems•Adverse Selection–People with a poor hidden characteristic…–take advantage of other’s ignorance–Example: Sick people buying life insurance•Moral Hazard–People who can take hidden actions…– take advantage of other’s ignorance–Example: Making poor umbrellas–Example: Employees shirkingEcon 370 - Asymmetric Information 9Adverse Selection Example•A company offers Health insurance•Each illness costs $100,000•Two types of people:–“Healthy”–“Sick”–Insurance company cannot distinguish them•Types of people differ in probability of getting sick and in willingness to pay for insuranceEcon 370 - Asymmetric Information 10Adverse Selection•Actuarially Fair insurance charges rates exactly equal to the cost to insure•A Pooling Equilibrium is one in which everyone is charged the same rates, regardless of typeType% of PopulationRisk of IllnessWillingness to PayHealthy 90% 1/1000 $200Sick 10% 1/100 $1,500Cost to Insure$100$1,000Econ 370 - Asymmetric Information 11Pooling Equilibrium•If the insurance company pools everybody, it would charge:–0.9 × 100 + 0.1 × 1000 = $190•Which everyone is willing to pay•So a Pooling Equilibrium existsType% of PopulationRisk of IllnessWillingness to PayHealthy 90% 1/1000 $200Sick 10% 1/100 $1,500Cost to Insure$100$1,000Econ 370 - Asymmetric Information 12Example 2•If the insurance company pools everybody, it would charge: 0.8 × 100 + 0.2 × 1000 = $280•Which only the sick are willing to pay•So there is NO Pooling Equilibrium exists•The insurance company must charge $1,000Type% of PopulationRisk of IllnessWillingness to PayHealthy 80% 1/1000 $200Sick 20% 1/100 $1,500Cost to Insure$100$1,000Econ 370 - Asymmetric Information 13Observations•Since the company cannot tell “sick” people from “healthy” people•It can only charge a single average rate•Although it would happily insure everyone at fair rates–And people would willing pay those rates•It cannot because it cannot tell people apart•Therefore a majority are uninsuredEcon 370 - Asymmetric Information 14Responses•Some market players lose as a result of asymmetric information•So they have developed strategies to (partially) overcome the problem•Two main strategies–Signalling–ScreeningEcon 370 - Asymmetric Information 15Screening•Screening:–is an action taken by the ignorant party –to determine types of people•In general,–It is a cost imposed on the “low-value” party–That the “high-value” parties are unwilling to endureEcon 370 - Asymmetric Information 16Screening Example•Average cost to insure everybody: –0.5 × 100 + 0.5 × 200 = $150•Which only the sick are willing to pay•Since there is no pooling equilibrium, –the insurance company must charge at least $200Type% of PopulationRisk of IllnessWillingness to PayCost to InsureCost of PhysicalHealthy 50% 1/1000 $140 $100 $40Sick 50% 1/500 $250 $200 $150Econ 370 - Asymmetric Information 17Screening Policies•Suppose the insurance company offers two policies–One for $240 with no restrictions–One for $100 but you must pass a physical to get it•Anyone can “pass” the physical–But “sick” people have to bribe the doctor to do itType% of PopulationRisk of IllnessWillingness to PayCost to InsureCost of PhysicalHealthy 50% 1/1000 $140 $100 $40Sick 50% 1/500 $250 $200 $150Econ 370 - Asymmetric Information 18Equilibrium•Healthy people–Are unwilling to buy the $240 policy–But will pay the $100 + $40 to get the other policy•Sick–Are willing to buy the $240 policy–Would pay the $100 + $150 for the other policy,–But, it is more expensive than the original policyType% of PopulationRisk of IllnessWillingness to PayCost to InsureCost of PhysicalHealthy 50% 1/1000 $140 $100 $40Sick 50% 1/500 $250 $200 $150Econ 370 - Asymmetric Information 19Screening Observations•The insurance company imposes a