TOPIC 24

Frontiers of microeconomics

ASYMMETRIC INFORMATION
• It is generally assumed all parties to a
transaction have access to the same information.

• A difference in access to relevant information is

called information asymmetry.
– Some parties may have private information that others
don’t have.

• This has implications for how markets work.

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 ASYMMETRIC INFORMATION
• A seller may have better information than buyer
– when buying a second-hand car, vendor knows more
than buyer.

• Buyer may have better information than seller

– when buying health insurance, buyer knows more
than seller

• In context of the global financial crisis

– the borrowers (the sellers of a financial contract) may
have had better info than the lenders (the buyers).

ASYMMETRIC INFORMATION
• Labour Market
– Workers may have better information than employer &
may undersupply effort if their effort is unobserved.

• Insurance Market
– Having purchased insurance a consumer may
undersupply effort in taking care of the insured object
if the insurer cannot observe this.

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 TYPES OF ASYMMETRIC
INFORMATION
• Info asymmetries can have effects before a
transaction is done by hidden information.
– Taking advantage of private information before a deal
is done is called pre-contractual opportunism or
adverse selection.

• Info asymmetries can also have effects after a

transaction is done by hidden action.
– Taking advantage of private information after a deal is
done is post-contractual opportunism or moral
hazard.

ADVERSE SELECTION – EXAMPLE 1

• The market for used cars (lemon’s problem)
– The vendor of a used car has better info about its
quality than a potential purchaser.
– If it is lemon – a poor quality vehicle – the vendor
may have an incentive to not reveal this info.
– Because of this buyers are apprehensive about
getting a ‘lemon’.
• Potential purchasers of what are claimed to be good cars
will underbid because there is a chance the car is a lemon.
• But at a lower bid price fewer (perhaps no) better quality
used cars will be offered.
– The market for quality cars may disappear!

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ADVERSE SELECTION – EXAMPLE 2
• The market for labour
– Workers (sellers of labour) vary in their abilities and
they may know their own abilities better than do the
firms that hire them.
– When a firm cuts the wage it pays, the more
talented workers are more likely to quit, knowing
they are better able to find other employment.
– Conversely, a firm may choose to pay an above-
equilibrium wage to attract better workers.

ADVERSE SELECTION – EXAMPLE 3

• The market for insurance
– Buyers of health insurance know more about their
own health problems than do insurance companies.
– Because people with greater hidden health
problems are more likely to buy health insurance
than are other people
• the premium of health insurance reflects the costs of a
sicker-than-average person.
– As a result, people in average health may decide
not to buy it.
• This leaves insurance firms with only high health risks
– So eventually no insurance may be offered.

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ADVERSE SELECTION – SUMMARY
• Nature of the Problem
– In these examples one side of the market (buyer or
seller) has incentives to conceal info from the other
(seller or buyer).
• Thus it is a hidden information issue.
– One side of the market won’t know the hidden info but
assume the other side has incentives to conceal it.

• Implications
– In extreme situations the market may disappear
completely even though buyers want to buy at prices
sellers would be willing to accept.
– A market fails to exist.

ADVERSE SELECTION – SOLUTIONS

• Signalling is an action taken by an informed
party to reveal private information to an
uninformed party.
– For example, the use of highly paid celebrities in
advertising signals the quality of a product to
consumers.
– Providing evidence of health to insurance companies.
– University degrees signal the abilities of a worker to
the employers.
• A signal must be costly.
– If a signal were free, everyone would use it and it
would convey no information.

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ADVERSE SELECTION – SOLUTIONS
• Screening is an action taken by an uninformed
party to induce an informed party to reveal
information.
– A person buying a used car may ask that a mechanic
check it over before the sale.
• A seller who refuses this request reveals that the car is most
likely a lemon.
– An insurance company may require medical
examination or exclude claims for a certain period
• A buyer refusing to comply reveals that he has pre-existing
health issues

MORAL HAZARD – EXAMPLE 1

• The Principal-Agent problem
– Tendency of a person who is imperfectly monitored
to engage in dishonest or otherwise undesirable
behaviour.
– the employment relation – the worker is agent,
employer the principle.
• If an employer cannot monitor a worker (check that they
are working hard) there are incentives for workers to be
slack.
• This is shirking - involves agents undersupplying effort as
a hidden action.
– the board-shareholder relation – the board is agent
working for shareholders’.

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 MORAL HAZARD – EXAMPLE 2
• Property insurance
– People who fully insure property may not ‘take care’
of the property sufficiently.
• Firms with fire insurance may be less likely to buy fire
extinguishers
• Similarly households may locate their homes near rivers
with a risk of flooding or near forests with bushfire risks
because insurance companies / governments contribute to
disaster relief while they enjoy the scenic views
• Persons with car insurance may drive more recklessly or
leave their cars unsecured more often

MORAL HAZARD – SUMMARY

• Nature of the Problem
– In these cases one side of a market has incentives to
conceal their behaviour after a deal is done.
• Thus these are hidden action issues.
– One side of the market won’t know the hidden
behaviour/action but assume the other side has
incentives to conceal it.

• Implications
– Again the side of the market subject to the info
disadvantage will change the way they do business &
in extreme cases may not do business at all.

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 MORAL HAZARD – SOLUTIONS
• Better monitoring
– Firms checking on workers through technology such
as spy cams, biometrics, etc
– Parents hiring babysitters have been known to plant
hidden video cameras (nanny cams) in their homes

• Efficiency wages
– Employers may choose to pay their workers a wage
that is above the equilibrium wage
– A worker who earns an above-equilibrium wage is less
likely to shirk, because if they are caught and fired it
will be very hard for them to find a similar high-paying
job.

MORAL HAZARD – SOLUTIONS

• Delayed bonus payments
– If a worker is caught shirking they miss their year-end
annual bonus.

• Employee stock ownership

– Firms can give workers stocks or stock options that
allow them to share in the profitability of the company
directly.
– The ownership stake aligns incentives of the
employees to those of the firm.

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 IN GENERAL
• Asymmetric information gives new reasons to
be wary of markets.
– When some people know more than others markets
may not put resources to their best uses.
• Sellers of high quality cars find it hard to sell their cars
• People with good health may have trouble buying low-cost
insurance
– Indeed, in extreme cases, markets may fail to exist.

POLITICAL ECONOMY
• The application of economic concepts and
methods to the study of how government
works.

• One particular area on interest is majority

voting
– It involves making decisions by taking a vote on
alternatives & choosing the most preferred
alternative.
– Assume that there are three alternatives A, B, C
• what you want after a vote is an ordering telling you which
alternative people prefer most.
– This involves problems.

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 DESIRABLE PROPERTIES FOR A
VOTING SYSTEM
• Transitivity
– if A is preferred over B, and B is preferred to C, then
A is also preferred to C.

• Independence of irrelevant alternatives

– the ranking between any two outcomes A and B
should not depend on whether some third outcome
C is also available.

CONDORCET VOTING PARADOX

• The Condorcet paradox occurs when majority
rule fails to produce transitive preferences for
society.
– Consider the following example

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 CONDORCET VOTING PARADOX
• Following the majority voting system
– Star Wars is majority preferred over Harry Potter.
• Kirk and McCoy both have this ordering
– Harry Potter is majority preferred over Police
Academy.
• David and Spock both have this ordering
– But Police Academy is majority preferred over Star
Wars.
• Spock and McCoy both have this ordering)

• The preference ordering is not transitive

– you cannot choose which is best using ‘majority rule’.

CONDORCET VOTING PARADOX

• One implication of the Condorcet paradox is
that the order in which things are voted on can
affect the result.
– Conducting a vote (Pairwise)
• Start with a comparison of Star Wars and Harry Potter and
then compare the winner with Police Academy

• In a comparison of Star Wars and Harry Potter, Star Wars

is the winner (majority preferred)

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CONDORCET VOTING PARADOX
– Conducting a vote (Pairwise)
• Now compare Star Wars with Police Academy

• Police Academy is majority preferred over Star Wars.

– Police Academy is chosen.

CONDORCET VOTING PARADOX

– Conducting a vote (Pairwise)
• Now start with a comparison of Harry Potter and Police
Academy and then compare the winner with Star Wars

• In a comparison of Police Academy and Harry Potter, Harry

Potter is the winner (majority preferred)

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 CONDORCET VOTING PARADOX
– Conducting a vote (Pairwise)
• Now compare Harry Potter with Star Wars

• Star wars is majority preferred over Harry Potter.

– Star Wars is chosen.

• The lesson is that majority voting by itself does

not tell us what outcome a society wants.

BEHAVIOURAL ECONOMICS
• Recently, behavioural economics has emerged
– economists make use of psychology to examine
how people actually make decisions rather than
relying on the assumption of rationality.

• The bases on which people do make decisions

is rich
– a fact appreciated even by Adam Smith in his
Theory of Moral Sentiments.

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 BEHAVIOURAL ECONOMICS
• Experiments by psychologists and economists
have shown that people are not always rational
– there are a number of systematic mistakes that
many people make
• People are overconfident – favour positive outcomes over
negative outcomes; e.g. creation of bubbles in housing
markets
• People give too much weight to a small number of vivid
observations ; e.g. fear of natural disasters
• People are reluctant to change their minds; they interpret
evidence according to their prior beliefs; considering
corona virus as being similar to earlier types of flu

BEHAVIOURAL ECONOMICS
• Another insight from behavioural economics is
that people care about fairness
• The ultimatum game demonstrates that players
care whether the outcome is ‘fair’ or not
– Structure of the game
• $100 is to be split between two people.
• Player A will propose to share the $100 with B.
• For example A might offer B $30 and keep $70 for herself.
• If B accepts the offer from A, the money is split as A
proposed.
• If B does not agree to the split then neither party gets
anything.
– Problem: How much should A offer B?

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 BEHAVIOURAL ECONOMICS
• Solution to the game
– Rationality suggests
• A should offer B the smallest amount possible amount (say
1 dollar) and keep the other $99 for herself.
• B should accept this since something is better than nothing
(which is what she gets after rejecting).

– Experimental economics indicates

• A’s offer is closer to a 50:50 split
• Moreover if A offers B much less than this B declines. hy?
• This suggests that B not only wants some gains here but
wants a ‘fair’ share of the gains.
• This is not rational but is widely-observed.

BEHAVIOURAL ECONOMICS
• Relevance to business decisions
– Assume I want to sell you my car.
• The minimum I will accept for my car is $5000 and
• the maximum you will pay is $6000.
– We should be able to agree at a price between
$5000-$6000.
– But suppose I will only sell for $5999 so I get $999
worth of surplus leaving you with $1. Will you
accept?
• You might but you might sense that I am getting an unfair
share of the surplus and not accept even though – as
person B in the ultimatum game – you would be better-off.

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 SUMMARY
• In many transactions, information is
asymmetric.
– With hidden actions, principals may be concerned
that they suffer from problems of moral hazard.
– With hidden information buyers (or sellers) may be
concerned about adverse selection.

• The Condorcet paradox shows that majority

rule may not produce transitive preferences for
society.

SUMMARY
• The study of psychology & economics reveals
that human decision-making is more complex
than assumed in conventional economic
theory.
– People do not always reflect self-interest alone -
they care about the fairness of economic outcomes.
– Thinking about things in this way offers new insights
about a basic issue of economics – namely how
people do a deal & how they share the ‘gains from
trade’.

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