Chapter 20 Asymmetric Information and Market Behaviour

© 2009 Pearson Education Canada20/1

Chapter 20Chapter 20

Asymmetric Information and Asymmetric Information and Market BehaviourMarket Behaviour


Asymmetric InformationAsymmetric Information

This Chapter examines cases of This Chapter examines cases of asymmetric (differing) information in asymmetric (differing) information in market exchanges.market exchanges.

The goal is to predict how exchanges The goal is to predict how exchanges will be organized to best manage the will be organized to best manage the subsequent transaction cost problems subsequent transaction cost problems that arise when buyers and sellers have that arise when buyers and sellers have different information.different information.


Figure 20.1 Incentives to produce low qualityFigure 20.1 Incentives to produce low quality


Figure 20.2 Incentives to produce high qualityFigure 20.2 Incentives to produce high quality


Sunk CostsSunk Costs

An interesting feature of the role of An interesting feature of the role of reputations is that they involve sunk reputations is that they involve sunk assets (costs). assets (costs).

It is the actual commitment of a real It is the actual commitment of a real resource that demonstrates goodwill.resource that demonstrates goodwill.

With asymmetric information, the fact that With asymmetric information, the fact that sunk costs do not affect the level of output sunk costs do not affect the level of output makes them the optimal method of makes them the optimal method of developing a reputation.developing a reputation.


The Hold-Up ProblemThe Hold-Up Problem

Whenever there is a large Whenever there is a large sunk costsunk cost (investment) involved in an (investment) involved in an exchange, there is the threat of a exchange, there is the threat of a hold-up problem ( (customers or customers or suppliers attempting to appropriate suppliers attempting to appropriate rents).rents).


Vertical Integration and Vertical Integration and Long-Term ContractsLong-Term Contracts

Two general solutions to the hold up Two general solutions to the hold up problem are:problem are:

1. Vertical integration - a firm firm buying another firm that supplies its buying another firm that supplies its inputs or markets its outputs.inputs or markets its outputs.

2.2. Long-term contracts-where firms Long-term contracts-where firms contractually agree to a price for contractually agree to a price for the entire life of the relationship.the entire life of the relationship.


Adverse SelectionAdverse Selection

Adverse selectionAdverse selection occurs when two occurs when two parties have different information.parties have different information.– For example, the selection of people who For example, the selection of people who

purchase insurance is biased in favour of purchase insurance is biased in favour of those who need it the most.those who need it the most.

Sick people are more likely to apply for Sick people are more likely to apply for health insurance than are healthy people, health insurance than are healthy people, but this characteristic may be but this characteristic may be hiddenhidden from from the insurer. the insurer.


Hidden CharacteristicsHidden Characteristics

Three assumptions are made in the Three assumptions are made in the analysis of the insurance industry:analysis of the insurance industry:

1.1. The probability of loss from a collision is The probability of loss from a collision is not uniform across drivers.not uniform across drivers.

2.2. Each driver is completely informed about Each driver is completely informed about his/her own characteristics.his/her own characteristics.

3.3. The driving characteristics of an The driving characteristics of an individual (high/low risk) are hidden from individual (high/low risk) are hidden from the insurance company.the insurance company.


Full-Information EquilibriumFull-Information Equilibrium

When identifying risk characteristics is When identifying risk characteristics is prohibitively expensive, if all drivers prohibitively expensive, if all drivers buy insurance, low-risk drivers pay buy insurance, low-risk drivers pay more than the equilibrium and high-risk more than the equilibrium and high-risk drivers pay less.drivers pay less.

Low-risk drivers subsidize insurance for Low-risk drivers subsidize insurance for high-risk drivers. high-risk drivers.


Full-Information Equilibrium

If the proportion of high-risk drivers is not If the proportion of high-risk drivers is not too high, then in equilibrium, all drivers too high, then in equilibrium, all drivers buy insurance and the low risk drivers buy insurance and the low risk drivers subsidize the high risk drivers.subsidize the high risk drivers.

If the proportion of high-risk drivers is too If the proportion of high-risk drivers is too large, then in equilibrium, only high-risk large, then in equilibrium, only high-risk drivers will buy insurance, and low-risk drivers will buy insurance, and low-risk drivers will be forced out of the market.drivers will be forced out of the market.


The Lemons PrincipleThe Lemons Principle

Assume there are only two types of used Assume there are only two types of used cars, lemons and jewels, and that cars, lemons and jewels, and that ascertaining whether a given car is a ascertaining whether a given car is a lemon or a jewel is prohibitively costly.lemon or a jewel is prohibitively costly.

All persons who want to sell their cars put All persons who want to sell their cars put them on the market, so the price of a used them on the market, so the price of a used car reflects the mix of lemons and jewels car reflects the mix of lemons and jewels for sale.for sale.



Some owners who want to sell their jewels Some owners who want to sell their jewels at a “fair price” may decide not to sell at at a “fair price” may decide not to sell at the market price (which includes lemons).the market price (which includes lemons).

As a result the proportion of lemons on the As a result the proportion of lemons on the market rises, further depressing the market rises, further depressing the market price, and inducing other jewel market price, and inducing other jewel owners to withdraw from the market.owners to withdraw from the market.



If all jewel owners make this choice, If all jewel owners make this choice, there will a market for lemons but not there will a market for lemons but not jewels.jewels.

Because of this Because of this hidden characteristichidden characteristic, , the jewels are driven out of the market the jewels are driven out of the market by the lemons (by the lemons (the lemon principlethe lemon principle).).


SignallingSignalling

Adverse selection is not a hopeless Adverse selection is not a hopeless problem. Individuals who are problem. Individuals who are disadvantaged can respond by disadvantaged can respond by signalling.signalling.

SignallingSignalling is a way for low-risk is a way for low-risk drivers to identify themselves to drivers to identify themselves to insurance companies.insurance companies.

One way to signal is to have some One way to signal is to have some form of low-risk certification.form of low-risk certification.


Low Risk CertificationLow Risk Certification

If the certificate is to produce an equilibrium, 3 If the certificate is to produce an equilibrium, 3 conditions must hold:conditions must hold:

1.1. Insurance companies must be convinced the Insurance companies must be convinced the certificate does signal low risk.certificate does signal low risk.

2.2. The cost to low-risk drivers must be low enough so The cost to low-risk drivers must be low enough so they have an incentive to acquire it.they have an incentive to acquire it.

3.3. The cost to high-risk drivers must be high enough so The cost to high-risk drivers must be high enough so they have no incentive to acquire it.they have no incentive to acquire it.


Signalling EquilibriumSignalling Equilibrium

If it is very costly for high-risk drivers to If it is very costly for high-risk drivers to obtain the signal and not too costly for obtain the signal and not too costly for low-risk drivers, then there will be a low-risk drivers, then there will be a signalling equilibrium in which low-risk signalling equilibrium in which low-risk drivers acquire the signal in order to drivers acquire the signal in order to differentiate themselves from high-risk differentiate themselves from high-risk drivers and obtain a lower insurance rate.drivers and obtain a lower insurance rate.


Moral Hazard Problems: Hidden ActionMoral Hazard Problems: Hidden Action

Moral hazardMoral hazard comes from the insurance comes from the insurance industry, where the probability of an industry, where the probability of an accident increased when it was insured.accident increased when it was insured.

People are less careful when they are People are less careful when they are insured for loss.insured for loss.



Suppose all drivers are identical and have the Suppose all drivers are identical and have the same probabilistic loss (L).same probabilistic loss (L).

If the driver spends some amount (C) on If the driver spends some amount (C) on accident prevention, the probabilistic loss of L is accident prevention, the probabilistic loss of L is reduced from reduced from qq to to qq’. ’.

The problem is that spending on C cannot be The problem is that spending on C cannot be observed by insurance companies (it is observed by insurance companies (it is hidden).hidden).



If all individuals could credibly promise to spend If all individuals could credibly promise to spend C on accident prevention, the price of full C on accident prevention, the price of full coverage would be coverage would be q’Lq’L and he/she would be and he/she would be better off.better off.

But, since the action is hidden, the promise is But, since the action is hidden, the promise is not credible, and the insurance companies will not credible, and the insurance companies will not offer insurance at this price.not offer insurance at this price.


DeductiblesDeductibles

One way for the insurance company to One way for the insurance company to solve this moral hazard problem is through solve this moral hazard problem is through the use of deductibles.the use of deductibles.

Deductible means that the insured Deductible means that the insured individual must pay some fraction of the individual must pay some fraction of the cost of the accident.cost of the accident.

This effectively prevents the person from This effectively prevents the person from having full insurance and people are having full insurance and people are willing to bear some costs (being more willing to bear some costs (being more careful) to avoid having to pay the careful) to avoid having to pay the deductible. deductible.

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Chapter 20 Asymmetric Information and Market Behaviour