Lecture #8

Asymmetric information 1:
adverse selection, signaling
 Asymmetric information
Assumption so far: perfect information
Now: imperfect information
Asymmetric information: the situation when one of the
parties to the transaction has more information than
the other.
Examples:
 the seller knows more about the good than the buyer,
 employees know more about their skills and talents than the
employers,
 the managers have more information about the production
costs, the firm’s competitive position in the market, and
investment potential, than the owners
 insurers lack significant information about the insured, which
is accessible to the latter.
 Asymmetric information leads to
erroneous market allocation!

• equilibrium may be not Pareto-optimal

• equilibrium may not exist
 Asymmetric Information in Markets

• In what ways can asymmetric information

affect the functioning of a market?
• Four applications will be considered:
– adverse selection,
– signaling,
– moral hazard (increased exposure to risk
when insured),
– incentivising.
 Adverse selection

On the seller’s part: crowding a better product out

of the market by a worse one; hidden information
leads to insufficient supply of the high-quality
product.

On the buyer’s part: crowding better clients out by

worse ones; increasing costs for the producer
exclude better clients from the market.
 Adverse Selection
• Consider a used car market.
• Two types of cars: (low-quality) “lemons” and
(high-quality) “peaches”.

• Each lemon seller will accept $1,000.

• Each lemon buyer is willing to pay at most $1,200.
• Each peach seller will accept $2,000.
• Each peach buyer is willing to pay at most $2,400.
 Adverse Selection
• If every buyer can tell a peach from a lemon,
then lemons sell for between $1,000 and
$1,200, and peaches sell for between $2,000
and $2,400. → Gains-to-trade when buyers
are well informed.
• But suppose no buyer can tell a peach from
a lemon before buying.
• What is the most a buyer is willing to pay for
any car?
 Adverse Selection
• Let q be the fraction of peaches.
• 1 – q is the fraction of lemons.
• Expected value (EV) to a buyer of any car
is at most
EV = $1200(1 − q) + $2400q.
• EV is the maximum price a buyer would be
willing to pay for a car.
 Adverse Selection

• Suppose $EV > $2000.

• Every seller can negotiate a price between
$2000 and $EV (no matter if the car is a
lemon or a peach).
• All sellers gain from being in the market.
 Adverse Selection

• Suppose $EV < $2000.

• A peach seller cannot negotiate a price
above $2000 and will exit the market.
• So all buyers know that remaining
sellers own lemons only.
• Then, buyers will be willing to pay at
most $1200 and only lemons are sold.
 Adverse Selection

• Hence, “too many” lemons crowd out the

peaches from the market.
• Gains-to-trade are reduced since no
peaches are traded.
• The presence of the lemons inflicts an
external cost on buyers and peach owners.
 Adverse Selection
• How many lemons can be in the market
without crowding out the peaches?
• Buyers will pay $2000 for a car only if
EV = $1200(1 − q ) + $2400q ≥ $2000
2
⇒q≥ .
3
q – the fraction of peaches
• So if over one-third of all cars are
lemons, then only lemons are traded.
 Adverse Selection

• A pooling equilibrium – A market equilibrium

in which both types of cars are traded and
cannot be distinguished by the buyers.

• A separating equilibrium – A market

equilibrium in which only one of the two
types of cars is traded, or both are traded
but can be distinguished by the buyers.
 Adverse Selection
• Low-quality products crowd high-quality
products out of the market.
• The market fails to supply mutually
beneficial transactions.
• Too many low-quality cars are sold in the
market and not enough high-quality ones.
• Adverse selection may lead to a situation
when only low-quality cars are sold in the
market.
 Adverse Selection
• In reality, differences in the cars’ quality may
not be that large.
• Sellers may also lack complete information.
• The car quality verification is possible to be
conducted by a buyer but is costly.
• Even with a low price, the supply of high-quality
cars will not fall to zero.
• However, compared with the complete
information case, many high-quality cars will
not be sold.
 Adverse Selection

• What if there is more than two types of

cars in the market?
• Suppose that
– car quality (= sellers’ value) is uniformly
distributed between $1000 and $2000,
– any car that a seller values at $x is
valued by a buyer at $(x+300).
• Which cars will be traded?
 Adverse Selection

1000 2000
Sellers’ values
 Adverse Selection
The expected value of any
car to a buyer is
$1500 + $300 = $1800.

1000 1500 2000

Sellers’ values

Sellers who value their cars at more than

$1800 exit the market.
 Adverse Selection
The distribution of values
of cars remaining on offer

1000 1800
Sellers’ values
 Adverse Selection
The expected value of any
remaining car to a buyer is
$1400 + $300 = $1700.

1000 1400 1800

Sellers’ values

Now sellers who value their cars between

$1700 and $1800 exit the market.
 Adverse Selection
• Where does this unraveling of the market
end?
• Let vH be the highest seller’s value of any
car remaining in the market.
• The seller’s expected value of a car is
1 1
× 1000 + × v H .
2 2
 Adverse Selection
• So a buyer will pay at most
1 1
× 1000 + × v H + 300.
2 2
• This must be the price which the seller of
the highest value car remaining in the
market will accept; that is,
1 1
× 1000 + × v H + 300 =≥ v H .
2 2
 Adverse Selection

1 1
× 1000 + × v H + 300 = v H
2 2
⇒ vH ≤= $1600.

Adverse selection drives out all cars

valued by sellers at more than $1600.

Crowding out high-quality cars

by low-quality ones.
 Adverse Selection
with Quality Choice

• So far, we have had constant numbers of

cars of each quality.
• Now consider a case when every seller can
choose the quality (or value) of her product.
• Two umbrella types: high-quality and
low-quality.
• Which type will be manufactured and sold?
 Adverse Selection
with Quality Choice
• Buyers value a high-quality umbrella at
$14 and a low-quality umbrella at $8.
• Before buying, no buyer can tell quality.
• Marginal production cost of a high-quality
umbrella is $11.
• Marginal production cost of a low-quality
umbrella is $10.
 Adverse Selection
with Quality Choice
• Suppose every seller makes only high-quality
umbrellas.
• Every buyer pays $14 and sellers’ profit per
umbrella is $14 - $11 = $3.
• But then a seller can make low-quality umbrellas
for which buyers still pay $14, so increasing profit
to $14 - $10 = $4.
• There is no market equilibrium in which only
high-quality umbrellas are traded.
• Is there a market equilibrium in which only
low-quality umbrellas are traded?
 Adverse Selection
with Quality Choice

• All sellers make only low-quality

umbrellas.
• Buyers pay at most $8 for an umbrella,
while marginal production cost is $10.
• There is no market equilibrium in which
only low-quality umbrellas are traded.
 Adverse Selection
with Quality Choice

• Now we know there is no market

equilibrium in which only one type of
umbrella is manufactured.
• Is there an equilibrium in which both types
of umbrella are manufactured?
 Adverse Selection
with Quality Choice

• A fraction q of sellers make high-quality

umbrellas; 0 < q < 1.
• Buyers’ expected value of an umbrella is
EV = 14q + 8(1 – q) = 8 + 6q.
• High-quality manufacturers must recover
the manufacturing cost, so
EV = 8 + 6q ≥ 11 ⇒q ≥ 1/2.
 Adverse Selection
with Quality Choice
• So at least half of the sellers must make high-
quality umbrellas for there to be a pooling
market equilibrium.
• But then a high-quality seller can switch to
making low-quality and increase profit by $1 on
each umbrella sold.
• Since all sellers reason this way, the fraction of
high-quality sellers will shrink towards zero.
• Then, buyers will pay only $8.
• So there is no equilibrium in which both umbrella
types are traded.
 Adverse Selection
with Quality Choice

• The market has no equilibrium

with just one umbrella type traded,
with both umbrella types traded.
• The only equilibrium is with zero production
of the umbrellas.
• Adverse selection has destroyed the entire
market!
 Adverse Selection
On a seller’s part:
• crowding a better product out of the market
by a worse one,
• hidden information leads to insufficient
supply of a high-quality product.

On a buyer’s part:
• crowding better clients out by worse ones,
• increasing costs for the producer exclude
better clients from the market.
Adverse selection – other examples
• the baseball player market: players moving to a
new MLB team are injured more often
Days on medical leave
First New change
contract contract in %
All 4.73 12.55 165.4
In the old team 4.76 9.68 103.4
In the new team 4.67 17.23 268.9

• mergers and acquisitions: the fact that we

succeeded in acquiring a company is a bad sign
as regards its value. Asymmetric information
eliminates part of the benefits that could be
gained from synergy.
Adverse selection – other examples
• life and health insurance
– more willing to buy life and health insurance will be:
• those whose health condition is bad,
• those with unhealthy lifestyle
• family members of those who suffer various health problems
• ...
– verifying such suspicions is costly for the insurer
• motor vehicle insurance
– buyers of insurance differ in:
• intensity of use of their car, driving skills
• manner of driving, care for the car
• their car’s technical condition
• ...
– many of these characteristics are not observable for
the insurer but are known to the insured
Adverse selection – other examples

• loans
– a significant component of the costs of credit is the
risk of default or delay in paying back the loan
– such risk depends on individual characteristics
– unreliable, dishonest persons, having difficulties in
sustaining employment etc. may be more willing to
take loans
– again, premiums rise, more reliable clients drop out
How to counteract adverse selection
of clients/buyers?
• restrict voluntariness
– mandatory insurance (role of the state, e.g. social
security)
– selling group insurance to firms
• mitigate asymmetry of information
– segregation into various risk groups (e.g. depending
on driver’s age, accident history, color of the car, etc.)
– bonus-malus arrangements, credit history etc.
 Avoiding adverse selection
(the seller)
– reputation
• rankings, information from others etc.
– standards
• e.g. McDonald’s, Holiday Inn (“No Surprises”) etc.
– warranties
• accepting complaints
– signalling quality
• certificates, diplomas etc.
 Signalling

• Question: How do potential employees

convince employers about the quality of
their services?
– weak signalling: dress (used as easily by the
low-quality employees as by the high-quality
ones)
– strong signalling: diploma (less effort required
to obtain it by higher-quality employees, thank
by the lower-quality ones)
 Signalling

• assumption: 2 groups of employees:

– group 1: low productivity
• APL = MPL = 1
– group 2: high productivity
• APL = MPL = 2
– groups 1 and 2 are of equal sizes
• APL for the joint group of employees = 1.5
 Signalling

• purely competitive labor and product

market
– P = 10 000 Euro
– employees hired based on 10-year contracts
– group 1: TR = 100 000 Euro
• (1 x 10 000 x 10)
– Group 2: TR = 200 000 Euro
• (2 x 10 000 x 10)
 Signalling

• complete information
– w = MRP
– group 1: w = 10 000 Euro/year
– group 2: w = 20 000 Euro/year
• asymmetric information
– w = AP
– group 1 & 2: w = 15 000 Euro/year
– pooling equilibrium
 Signalling

• Signalling – education level

– y = number of years of university education
– C = costs of education
• Fees, cost of books, effort, opportunity costs etc.
– group 1  C1(y) = 40000y Euro
– group 2  C2(y) = 20000y Euro
 Signalling
• costs of education are higher for the low-quality
employees
– more effort, more expenses (e.g. private lessons,
fees for repeating the year)
• decisions regarding remuneration (wage):
– y=y* signals that the employee belongs to group G2
and obtains remuneration (wage) = 20 000 Euro
– y below y* signals that the employee belongs to group
G1 and obtains remuneration (wage) = 10 000 Euro
• y* is an arbitrary level, however must be
identifiable by employers
 Signalling

• how many years of education will both groups of

employees choose?
• goal: obtaining such education level which
assures that benefits from it will be higher than
costs of obtaining it
• For group 1 it does not pay to study for y* years,
i.e.
– 100 000 < 40 000y*, y* > 2.5
• group 2 does study:
– 100 000 > 20 000y*, y* < 5
 Signalling

• there is no reason to study less than y* years

because remuneration (wage) will then be the
same as in the case of no education
• Similarly, there are no incentives to obtain
education higher than y* because this will not
cause an increase in the remuneration (wage)
 Signalling
• the equilibrium will be found within the interval of
y* between 2.5 and 5
• if y* = 4
– members of group 1, minimazing their costs, will not
study
– for members of group 2 education will be
remunerative up to 4 years of university studies y* = 4
• the employer will read the signals given by
potential employees and employ them at
adequate remuneration levels
(separating equilibrium)
 Signalling
Value of
Group 1 Group 2
Value of
education education

200K 200K
C1(y) = 40 000y C2(y) = 20 000y

100K 100K
B(y) B(y)

0 1 2 3 4 5 6 Years of 0 1 2 3 4 5 6 Years of
study study
47
optimal choice of y optimal choice of y
group 1 y* group 2 y*
 Other examples of signalling

• piles of books are a

signal of quality
• because printing
something of low quality
in such large quantity
could result in bankrupcy
• similarly: expenses on
advertisement, marketing
campaigns etc.
 Signalling – summary

• education pays off even if everything that

we/you learn during our/your studies is
useless for our/your work
• the university diploma is a signal of talent
and willingness to work hard
• vide: demand for physicists
• in order to work, the signal must:
– be relatively costly for the ‟low quality” group
– be understandable for both sides of the market