Assymetric Information - Iman Sufrian

7/23/2019 Assymetric Information - Iman Sufrian

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Review JournalMarket with Asymmetric Information: The Contribution of George Akerlof,

Michael !ence an" Jose!h tiglit#$y %arl&Gustaf 'ofgren, Torsten (ersson, Jorgen )* )eibull,

Scandinavian Journal of Economics+ ol* -./, 01*2 3Jun*, 2..24 , !!* -56&2--

Reviewe" by Iman ufrian0(M -2.78-859/

A* $AC%GR10;<I0TR1;CT1R=

The introductory paragraph summarizes the background information and purpose of the

research (specific questions the study researched).

Research on incentive schemes and market equilibrium in situations with asymmetric

information contributes large part of economic theory. Those research on market

equilibrium and incentives schemes are largely based on theory contributed by three

researchers namely: George Akerlof, ichael !pence and "oseph !tiglit#. Those

three researchers and authors contribute significantly on how economist think about

the functioning of markets. Analytical methods suggested by those three researchers

have been applied in e$plaining a wide spectrum of social and economic interaction,

especially different types of contracts.

Asymmetric information is widely accepted as a common feature of market

interaction. This feature immediately give rise to a number of questions. %or

e$ample: if the buyer of insurance policy usually knows more about his individual risk

than the insurance company, what would happen to the police insurance price,

number of police insurance sold and the quality of police insurance& 'f certain

individual know better about his own risk profile, what can he do to improve his

individual market outcome& (hat can the insurance company do to e$tract more

relevant information from insurance buyers& !uch questions can be answered by

using the analytical method suggested by Akerlof, !pence and !tiglit#.

The purpose of this paper try to discuss about the contribution of those three

researcher in economic theory, specifically on asymmetric information market topic.

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$* M>T?1;1'1G=

Then, explain the methods that were used to investigate the research questions (use past tense).

Authors of this paper conducted a wide literature review of Akerlof)s, !pence)s and

!tiglit#)s works, especially on asymmetric information topic. *ased on literaturereview, the authors of this paper then summari#e and synthesi#e the contribution of

Akerlof, !pence and !tiglit# on asymmetric information topic.

Authors of this paper also conducted literature review of other researchers that

applied and tested Akerlof)s, !pence)s and !tiglit#)s ideas.

C* J1R0A' C10T>0T

ention the ma!or results of the study (use past tense).

"tate what the author of the study learned.

-* Contribution of George Akerlof

Akerlof)s article, +The market for -emons): uality /ncertainty and the arket

echanism0 123456, was seen as a seminal paper on economics of information.

Akerlof)s essay analysed a market for a product where sellers knew more of the

quality of the products they sold that the buyers. Akerlof gave a used cars market as

an e$ample. 7e modelled the used cars market as followed:

a. There were two qualities of goods available. They were high quality goods and

low quality goods in fi$ed shares 8 and 928;b. <ach buyer was interested only one unit of good but unable to observe the

difference between the two qualities at the time of purchase.c. All buyers had the same valuation of the two qualities: one unit of low quality was

worth w- and one unit of high quality worth w7. w- = w7

d. <ach sellers knew the quality of the units he sold and valued low quality units at

v- and high quality units at v7. v- = v7.e. 'f separate markets had e$isted for low quality goods and high quality goods,

every price between v- and w- would have supported beneficial transactions for

both parties in the market for low quality, as would have for every price between

v7 and w7 for high quality goods. Those transactions would have been socially

efficient outcome: all gains from trade would have been reali#ed.f. 7owever, if the market was not regulated and the buyers were unable to

distinguish the quality between low quality and high quality products, dishonest

sellers of low quality goods would chose to trade in high quality market. 'n reality,

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the market would merge into one single market with one and the same price for

all units. 'f this occurred, then the valuation of high quality was higher than the

consumer)s average valuation. This was shown algebraically as follows v7 > ?

where ? was given by ? @ 8 w - 928; w7. 'f both quantities were sold, the high

quality good only sold at most ?.

'mplication of Akerlof)s model:

a. !ince high quality goods are only sold at ? where v7 > ?, high quality sellers

would leave the market until only low quality goods remained for sale in the

market. This was seen as the market failure since invisible hands of classical

Adam !mith)s proofed ineffective to predict that both goods were sold at its fair

value.

b. Another fundamental insight from Akerlof)s work is that economic agent)s

attempts to protect themselves from adverse consequences of informational

asymmetries e$plained e$isting institution. %or e$ample, guarantees offered by

professional sellers was one of the e$ample.

Akerlof)s later article, +the <conomics of caste and of the Ratrace and Bther woeful

Tales 1234C6, was a more thorough discussion of the significance of asymmetric

information in widely differing conte$ts. 'n this article, Akerlof showed how certain

variables, called +indicators0, may not only provided important efficiencyenhancing

economic information, but may also cause the economy trapped in an undesirable

equilibrium. Akerlof gave an e$ample of sharecropping, where tenancy was repaid by

a fi$ed share of the harvest, a tenant)s volume of production acted as an indicator of

his work effort on the farm.

Akerlof also gave significant contribution in enriching economic theory with insights

from sociology and social anthropology. !ome of his paper on labour market had

e$plained how emotions such as +reciprocity0 towards an employer and +fairness0

towards colleagues could contribute to higher wages and thereby unemployment.

This Akerlof)s idea revealed in his article 123D5b, 23DEc6. 7is idea was confirmed

both e$perimentally and empirical support from interview surveys conducted by %ehr

and !chmidt 12333, E5556 and *ewley 123336.

2* Contribution of Michael !ence

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!pence)s most important works showed how economic agents in a market could use

signalling to mitigate the effects of adverse selection problem. <conomic agents tried

to convince the opposite party of the value or quality of their product. !pence)s main

contribution were to develop and formali#e this idea and to show and to analyse its

implications.

!pence modelled a labour market and used education as a signal in the labour

market in his seminal paper +"ob arket signalling 1234Fa6 and his book arket

!ignalling 12346. 7e modelled Hob market as followed:

a. An employer could not distinguished between high and low productivity labour

when hiring new workers.b. "ob applicants 9the sellers; could acquire education before entering the labour

market.c. The productivity of lowproductivity workers, w-, is below that of high productivity

workers w7, and the population shared of the two groups were 8 and 28.d. Although, the employer could not directly observed the productivity of workers,

the employers could observe the worker)s educational level. <ducation was

measured on a continuous scale sI5, and the necessary cost J in terms of effort,

e$penses or time to reach each level is lower for highproductivity individuals.e. To focus on signalling aspect, !pence assumed that education did not affect a

worker)s productivity, and education had no consumption value for the individual.

Therefore, under perfect information, perfect competition and constant return to

scale, all applicants would chose as little education as possible. 7owever, under

asymmetric information, by contrast, high productivity workers might acquire

education as a signal of their ability.f. All employers e$pect all Hob applicants with at least a certain educational level

with s7 > 5 to have high productivity. This implied uneducated workers 9s@5; was

seen as low productivity workers. /nder perfect competition and constant return

to scale, all applicants with educational level s7 or higher were offered a wage

equal to their e$pected productivity, w7, whereas those with lower educational

level are offered the wage w-. Given this wage schedule, each Hob applicant

would choose either the lowest possible education s-@5 ant obtain low wage w-,

or the higher educational level s7 and the higher wage w7. An education between

these levels did not yield a wage higher than w- but cost moreK similarly, an

education above s7 did not yield a wage higher than w7, but cost more.

g. "ob applicants) preferences were represented by two indifference curve, which

were drawn to capture the assumption that education was less costly for high

4



productivity individuals. The flatter curve represented those education wage

combination 9s,w; that high productivity individuals found equally good as their

e$pected education J wage pair 9s7, w7;. All points northwest of this curve were

regarded as better than this alternative, while all points to the southeast were

regarded as worse. !imilarly , the steeper curve through * indicated education

wage combination that low productivity worker individuals found equally good as

the minimum education s-@5 and wage w-.

'mplication of !pence model:

a. 7igh productivity individuals chose educational level s7, neither more nor less

and receive the higher wage, as this alternative A gave the better outcome than

alternative *. !imilarly, low productivity individuals optimally chose s @ 5 an

received w- at point *. -ow productivity workers were worse off with alternative A

as the higher wage did not compensate the high cost of education. <mployers)

e$pectation that workers with different productivity chose different level of

educational level are indeed selffulfilling in this signalling equilibrium. -abour

market did not e$perience market failure where high productivity individuals

remain outside of the Hob market 9e.g. by moving away or setting up their own

business;, instead these workers participated in labour market and acquire a

costly education solely to distinguish themselves from low productivity individuals.b. 7owever this equilibrium was fulfilled if the e$pected level of education were

neither too high that high productivity applicant prefer to refrain from education

or , or so low that low productivity applicants prefer to educate themselves up to

that level.c. !pence indicated that a certain signalling equilibrium is the socially most efficient.

'n this equilibrium, high productivity individuals prefer to acquire minimum

education level to distinguish themselves from low productivity individuals.

d. !pence also showed the e$istence of other equilibria, with modified model where

no applicants acquired education if the employer did not e$pect education was a

productivity signal. <mployers e$pected that all applicants would have average

level of productivity on the market regardless their level of education.e. !pence also stated the e$istence of possibility of equilibria where different groups

of applicants had different educational incentives. %or e$ample, high productivity

men 9black; may be e$pected to acquire another lever of education than equally

productive women 9whites;. 'n such equilibria, the return to education differed

5



between men and women, or black and whites, as do their investment in

education.

!pence also contributed to the field of industrial organi#ation. 7is model of market

equilibrium under monopolistic competition had also been influential in other fields

such as growth theory and international trade

8* Contribution of Jose!h tiglit#

!tiglit#)s most important articles was written together with Rothschild on adverse

selection +<quilibrium in Lompetitiv 'nsurance arkets: An <ssay on the <conomic

of 'mperfect information 1234Cd6. This article was seen as a natural complement to

the analysis of Akerlof articles and !pence)s articles. !tiglit# and Rothschild started

with the question of what uninformed agents could do to improve their outcome in a

market with asymmetric information.

;* MMAR=

#nclude a summary as well as your own analysis and evaluation of the article.

$now the article thoroughly.

%o not include personal opinions.

&e sure to distinguish your thoughts from the author's words.

ocus on the positive aspects and what the author(s) of the study learned.

ote limitations of the study at the end of the essay*

o %o the data and conclusions contradict each other+

o #s there sufficient data to support the author's generalizations+

o hat questions remain unanswered+

o -ow could future studies be improved+

*ased on above parts, this articles has provided a thorough framework on the theory

of adverse selection which is firmly based on the e$istence of asymmetric

information of market interaction. This theory of adverse selection, its consequences,

and economic agent can act to e$tract private informationMhidden information from

6



opposite party in order to improve his economic outcome are largely based on works

of three researcher namely George Akerlof, ichael !pence and "oseph !tiglit#. The

contribution of those three authors can be summari#ed as follows:

2. George Akerlof demonstrated how informational asymmetric can create adverse

selection problem in markets.E. (hile ichael !pence showed that better informed economic agents in

asymmetric information market may have incentives to take certain actions to

give signals to uninformed agent, in order to improve their market outcome.F. !tiglit# mentioned how poorly informed economic agents can e$tract private

information from those who are better informed by offering a set of alternative

contracts for a specific transaction, usually called screening through self

selection.

This articles also review other authors) works that applied and tested the work of

these three researchers) works. ost of other authors) works that try to apply and

test the models suggested by George Akerlof, ichael !pence and "oseph !tiglit#

confirm the prediction of the models.

oreover, the models suggested by those three author also successfully applied in

many other economic and social settings for e$ample financial economics, industrial

organi#ation. 7owever, some attempts to test the prediction of the models suggested

by Akerlof did revealed some ambiguous results. %or e$ample a direct test carried

out by *ond 923DE; on data from a market for secondhand small trucks did not

support the asymmetric information hypothesis. Lhiappori and !alanie 9E555;

e$amined whether individuals who buy car insurance car insurance with better

coverage have more accidents. 7owever, they failed to find statistical support for

such correlation as suggested by adverse selection and signalling model. The

difficulty of such tests is to distinguish between adverse selection and moral ha#ard

problemK another is that screening and signalling partially eliminate the effect of

informational asymmetries.

Recently, many insights from economics of information have been incorporated into

development economics. This phenomena can be seen as

Organization

7



The introductory paragraph summarizes the background information and purpose of the

research (specific questions the study researched).

Then, explain the methods that were used to investigate the research questions (use past tense).

ention the ma!or results of the study (use past tense).

"tate what the author of the study learned.

Critique: A Critical Review and Assessment of the Article

#nclude a summary as well as your own analysis and evaluation of the article.

$now the article thoroughly.

%o not include personal opinions.

&e sure to distinguish your thoughts from the author's words.

ocus on the positive aspects and what the author(s) of the study learned.

ote limitations of the study at the end of the essay*

o %o the data and conclusions contradict each other+

o #s there sufficient data to support the author's generalizations+

o hat questions remain unanswered+

o -ow could future studies be improved+

R>@>R>0C>

7olcombe, Randall GK !obel, Russell !., +Lonsumption e$ternalities and economic

welfare,0 Eastern Economic Journal K !pring E555K Nol EC Oo. EK 2P4.

Qindyck, Robert !.K Rubinfeld, aniel -., Microeconomics 9Frd edition;, Qrentice 7all,

233C,

Narian, 7al R., Intermediate Microeconomics – A Modern Approach 9%ifth <dition;,(. (. Oorton S Lompany, Oew ork-ondon, 2333.

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Assymetric Information - Iman Sufrian