Asymmetric Information Revised: October 22, 2001 Many business situations are plagued by information difficulties, in which one party to a transaction has better information than the other. (Think of the phrase: “Trust me on this.”) We refer to these situations as having “asymmetric information.” Inevitably, the party with superior information is tempted to exploit its advantage. And even if it isn’t, the other party may think it will. And the uninformed part has some leverage, too: it can walk away walking away from a deal may offer it some leverage. The result is one of the most interesting and challenging aspects of business. Consider these examples: •= Health insurance company faces pricing dilemma. A low price leads to small margins. But a high price runs the risk of attracting only high-risk patients. What should it do? We refer to its problem as “adverse selection,” since the high-risk patients are more likely to “select” the plan. The problem is that the health of a patient may be known better by the patient than the insurance provider. •= Large firm would like to spin off subsidiary. Potential buyers ask: Is this a strategic move (the firm wants to concentrate on other businesses) or an attempt to unload what it knows to be an unprofitable business? •= Price as signal of quality. New firm enters market for luxury luggage. Would like to reduce price to gain market share, but worries that this might be interpreted by customers as a sign of low quality. You get the idea. Information can be a serious friction to doing business. This class is devoted to exploring some of the ramifications of asymmetric information in stylized settings where the issues are clear, if a little unrealistic. We return to reality at the end and discuss ways in which information problems might be ameliorated. Games with Asymmetric Information Games with asymmetric information are simply games where one player has better information than the other. We can find many examples of asymmetric information in day-to-day life. When people apply for health insurance they often know more about their health status and history than the insurer. Manufacturers of products often know more about the quality of their product than do consumers. Firms presumably know more their assets than potential buyers. In a legal setting, defendants often know more than plaintiffs. And in Edgar Allen Poe’s “Telltale Heart,” the guilt-ridden criminal Firms and MarketsLecture NotesInformation Page 2 knows about his crime while the investigators do not. (And, if he had kept his cool, he would have probably remained a free, yet disturbed, man.) To see how asymmetric information affects strategic games between competitors, we can look at two polar cases. First, we can consider a game where the relatively less-informed player moves first. In this case, “adverse selection” becomes a risk for that first mover. Consider, for example, the case of litigation for medical malpractice. Before the trial proceeds to the discovery stage, it seems reasonable to assume the defendant has better information then the plaintiff. If the plaintiff makes the defendant an offer for an out-of-court settlement, he should take into account that such offer will be accepted if and only if liability is likely to be greater than the proposed settlement – the exact situation in which the plaintiff would want the offer not to be accepted. Second, we could consider a game in which the informed player moves second. In this case, the first move may tell the other player something about the first player’s move, which the first player will take into account. If a firm knows the quality of its product, could a buyer infer quality from the seller’s price? Typically the move by the first player contains information that the second player can use to make a better decision. The first player knows this, of course, and uses it to guide its choice. The takeaway point when the uninformed player moves first is that she must how the informed player will react: if this is really such a good deal, why is it being offered to me? The takeway point when the informed player moves first is that the move conveys information. The trick to to convey the right information. Selling “Lemons” Suppose the uninformed player moves first; what information will guide her strategy? The classic example is the sale of a used car. It made more sense in the 1970s than it does now, when car quality is uniformly higher. But the idea is that when you buy a used car from an individual, you probably know less about the quality of the car than the seller. You move first in the sense that you don’t observe any informative moves by the seller before you make an offer. The risk is that you might buy a “lemon” (meaning a low-quality car, not what you season your fish with). Consider a concrete example. In the game, the buyer makes an offer and the seller decides whether or not to take it. Suppose that you, a potential buyer of a used car, know from reading Consumer Reports that 50% turn out to be lemons. You decide that a lemon is worth zero and a non-lemon is worth 1500. If the chances of the two possibilities are 50% each, you might set your reservation price (the most you are willing to pay) at $750 based on the 50% probability of buying a dud [750 = (.5x0) + (.5x1500)]. Anything more, and you’d prefer to walk away. What about seller? Let us say that a seller would be unwilling to part with a non-lemon for less than 1000, the fair market value based on the blue-book value of the car, etc. Now we have a problem. Given your lack of information about whether you will get a lemon or not, you are willing to pay lessInformation Page 3 for the model than the reservation asking price of legitimate sellers. This means that anyone trying to sell you the car for your price is probably selling you a lemon! It only gets worse. Fearing that you will get a lemon at $750, you change your reservation price downward because you think the likelihood of getting a worthless lemon is now 90%. Thus, my new bid is 150 [=(.9x0) +(.1x1500)]. Now who on earth would sell you a car that, worth 1500 without defects, sells for only a tenth of this price? Only people selling lemons. As this downward spiral continues, both buyers and legitimate sellers drop out of the market until the