Hal Varian
Intermediate Microeconomics
Chapter Thirty-Six
Asymmetric Information
Information in Competitive Markets
In purely competitive markets all
agents are fully informed about
traded commodities and other
aspects of the market.
What about markets for medical
services, or insurance, or used cars?
Asymmetric Information in Markets
A doctor knows more about medical
services than does the buyer.
An insurance buyer knows more
about his riskiness than does the
seller.
A used car’s owner knows more about
it than does a potential buyer.
Asymmetric Information in Markets
Markets with one side or the other
imperfectly informed are markets
with imperfect information.
Imperfectly informed markets with
one side better informed than the
other are markets with asymmetric
information.
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
incentives contracting.
Adverse Selection
Consider a used car market.
Two types of cars; “lemons” and
“peaches”.
Each lemon seller will accept $1,000;
a buyer will pay at most $1,200.
Each peach seller will accept $2,000;
a buyer will pay at most $2,400.
Adverse Selection
Ifevery 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 are generated when
buyers are well informed.
Adverse Selection
Suppose no buyer can tell a peach
from a lemon before buying.
What is the most a buyer will pay for
any car?
Adverse Selection
Let q be the fraction of peaches.
1 - q is the fraction of lemons.
Expected value to a buyer of any car
is at most
EV $1200(1 q) $2400q.
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.
Buyers will 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
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
Soif over one-third of all cars are
lemons, then only lemons are traded.
Adverse Selection
A market equilibrium in which both
types of cars are traded and cannot
be distinguished by the buyers is a
pooling 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, is a
separating equilibrium.
Adverse Selection
What if there is more than two types
of cars?
Suppose that
car quality 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
Seller values
Adverse Selection
1000 1500 2000
Seller values
Adverse Selection
The expected value of any
car to a buyer is
$1500 + $300 = $1800.
1000 1500 2000
Seller values
Adverse Selection
The expected value of any
car to a buyer is
$1500 + $300 = $1800.
1000 1500 2000
Seller values
So 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
Seller values
Adverse Selection
1000 1400 1800
Seller values
Adverse Selection
The expected value of any
remaining car to a buyer is
$1400 + $300 = $1700.
1000 1400 1800
Seller values
Adverse Selection
The expected value of any
remaining car to a buyer is
$1400 + $300 = $1700.
1000 1400 1800
Seller values
So 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 value of
any car remaining in the market.
The expected seller 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
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 just
accept; i.e.
1 1
1000 v H 300 v H .
2 2
Adverse Selection
1 1
1000 v H 300 v H
2 2
v H $1600.
Adverse selection drives out all cars
valued by sellers at more than $1600.
Adverse Selection with Quality Choice
Now each seller can choose the
quality, or value, of her product.
Two umbrellas; high-quality and low-
quality.
Which 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.
Adverse Selection with Quality Choice
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
Allsellers 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,
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.
Adverse Selection with Quality Choice
Since all sellers reason this way, the
fraction of high-quality sellers will
shrink towards zero -- but 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
Adverse Selection with Quality Choice
The market has no equilibrium
with just one umbrella type traded
with both umbrella types traded
so the market has no equilibrium at
all.
Adverse Selection with Quality Choice
The market has no equilibrium
with just one umbrella type traded
with both umbrella types traded
so the market has no equilibrium at
all.
Adverse selection has destroyed the
entire market!
Signaling
Adverse selection is an outcome of an
informational deficiency.
What if information can be improved
by high-quality sellers signaling
credibly that they are high-quality?
E.g. warranties, professional
credentials, references from previous
clients etc.
