Department of Economics & Business
Module 13
Imperfect Information – Part 1
Ramya Shankar
Principles of Microeconomics ECO10250
Market Failure
• Externalities
• Public Goods
• Imperfect Information or Asymmetric Information
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Asymmetric Information
Some agents in the market have more information about important market variable
than others.
Examples
• The seller often knows the quality of her product. A first time buyer may not
know the quality.
• Employees know how hard they are working. The employer may not be able to
fully monitor employee effort.
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Asymmetric Information
Some agents in the market have more information about important market variable
than others.
Examples
• The seller often knows the quality of her product. A first time buyer may not
know the quality. Hidden Information
• Employees know how hard they are working. The employer may not be able to
fully monitor employee effort.
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Asymmetric Information
Some agents in the market have more information about important market variable
than others.
Examples
• The seller often knows the quality of her product. A first time buyer may not
know the quality. Hidden Information
• Employees know how hard they are working. The employer may not be able to
fully monitor employee effort. Hidden Action
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Formalized by Nobel Prize winning Economist George Akerlof.
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Formalized by Nobel Prize winning Economist George Akerlof.
Lemons (50)
Car Dealership
Plums (50)
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Formalized by Nobel Prize winning Economist George Akerlof.
Lemons (50)
Car Dealership
Plums (50)
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Formalized by Nobel Prize winning Economist George Akerlof.
Lemons (50)
Buyer
Car Dealership
Plums (50)
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Formalized by Nobel Prize winning Economist George Akerlof.
Lemons (50)
Buyer
Car Dealership
Plums (50)
Efficient Allocation ‐ All cars, lemons and plums should be transferred from the dealer to buyers.
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Formalized by Nobel Prize winning Economist George Akerlof.
Lemons (50)
Asymmetric Information Buyer
Car Dealership
Plums (50)
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Formalized by Nobel Prize winning Economist George Akerlof.
Lemons (50)
Asymmetric Information Buyer
Car Dealership
Plums (50)
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Formalized by Nobel Prize winning Economist George Akerlof.
Lemons (50)
Asymmetric Information Buyer
Car Dealership
Plums (50)
How much would the buyer be willing to pay for a car in the dealership?
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information Average
value to a
Formalized by Nobel Prize winning Economist George Akerlof. buyer of a
car in the
dealership
= $1,500
Lemons (50)
Asymmetric Information Buyer
Car Dealership
Plums (50)
How much would the buyer be willing to pay for a car in the dealership?
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information At $1,500,
the dealer
Formalized by Nobel Prize winning Economist George Akerlof. will only
sell
lemons!
Lemons (50)
Asymmetric Information Buyer
Car Dealership
Plums (50)
How much would the buyer be willing to pay for a car in the dealership?
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information Expected
Value of a car
Formalized by Nobel Prize winning Economist George Akerlof. that a dealer
offers to the
buyer = Value
of a Lemon.
Lemons (50)
Asymmetric Information Buyer
Car Dealership
Plums (50)
How much would the buyer be willing to pay for a car in the dealership?
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information Expected
Value of a car
Formalized by Nobel Prize winning Economist George Akerlof. that a dealer
offers to the
buyer = Value
of a Lemon.
Lemons (50)
Asymmetric Information Buyer
Car Dealership
Plums (50)
How much would the buyer be willing to pay for a car in the dealership?
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Outcome:
Hidden Information Only Lemons
Formalized by Nobel Prize winning Economist George Akerlof. get Sold.
Seller is left
with plums
that he
cannot sell!
Lemons (50)
Asymmetric Information Buyer
Car Dealership
Plums (50)
How much would the buyer be willing to pay for a car in the dealership?
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
• Adverse Selection
o Only the low quality (or high cost) good gets traded in the market.
• Market equilibrium is not efficient.
• Both, less informed agents and more informed agents lose out due to
asymmetric information.
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Other Examples
• Workers who switch employers get lower wages than equally productive “stayers”.
• Insurance companies charge high premiums covering only high risk individuals.
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY
Hidden Information
Solutions to Adverse Selection
• Market-based Solutions
o Seller can provide credible signals of quality, like getting a professional license,
providing warranties, getting a college degree.
o Buyers can screen for high quality goods – taking the car to the mechanic, requiring
individuals to get a health screening to get insurance.
• Government Solutions
o Requiring licenses for doctors, plumbers, electricians, architects etc.
o Insurance Mandates – Auto Insurance, Obamacare Mandate.
Prin of Microeconomics ECO10250, Prof. Ramya Shankar,
Department of Economics and Business, CCNY