Information Economics
Consider the following variants on the game of
poker:
The Certainty Game – 5 cards dealt face up so that all
players can see them
The Imperfect Information Game – 3 cards dealt face up
and 2 face down to each player
The Imperfect & Asymmetric Information Game – 3
cards dealt face up and 2 cards dealt face down to each
player – each player allowed to look at their own face
down cards
Information Economics
In the first game there is little/no incentive to
bet
In the second game each player is faced with
imperfect but symmetric information. Some
players may be better at judging how the
unseen cards may ‘add value’ to the hand so
there is a little scope for skill and betting
becomes more likely
Information Economics
In the third game each player has private
information
Imperfect & Asymmetric information creates
scope for strategic play
Bluffing & Misleading signals through the
use of body language & betting behaviour
Information Economics
Some transactions in markets &
organizations may feature full information
Many more feature a degree of asymmetric
& imperfect information
Hidden information
Hidden action
Hidden Information
Occurs when one party to a transaction has more
information than the other parties about some
exogenous fact relevant to the transaction
Examples include life insurance and Akerlof’s
market for lemons (2nd hand cars)
There is an incentive for pre-contract (ex-ante)
opportunism which induces adverse selection
Hidden Information in Markets
Originated in insurance markets
Asymmetric information between the insurer and
the insured
For medical insurance individuals know more about
their health than the insurer
Individuals have a better idea of whether insurance
is a ‘good deal’
Insurers tend to end up insuring ‘bad risks’ –
adverse selection
Medical Insurance
Cost of heart by-pass operation is constant at
c
The size of the population is N
The number of operations performed per
annum is n
If everyone was insured:
Prave=n/N
Medical Insurance
If everyone insured the average pay-off
would be:
Prave=c
If the insurer set the premium equal to c he
would break even
This presumes everyone takes out the
insurance
What if they do not?
Medical Insurance
Assume all individuals are risk-neutral and
that individuals have better information
about their health than the insurers
Pri is the individual’s assessment of the
probability of their making a claim – it is not
known by insurers
Medical Insurance
The individuals expected pay-off is:
Pri x c
The individual will opt for the medical
insurance iff:
Pri x c > Prave x c
Pri > Prave
Medical Insurance
Only those with a greater than average risk will
choose to insure
Under this scenario the insurer makes a loss
Insurer can raise premium but this forces more
individuals not to insure
Ultimately premiums are raised to the level where
no-one insures
This is the adverse selection problem
Medical Insurance
In practice individuals have different
attitudes to risk
Also many do not know precisely their own
level of risk
Akerlof’s Market for Lemons
2 second hand cars
Some information is readily ascertainable by
both sides to any potential transaction (buyer
& seller)
Some information is asymmetrically
distributed – it is known by the seller but not
by the potential buyer
Akerlof’s Market for Lemons
The ‘value’ of a good second-hand car is
£10,000
The ‘value’ of a lemon is £5,000
Assume that 50% of cars are good and 50%
are ‘lemons’
The market price will be £7,500
Akerlof’s Market for Lemons
Owners of lemons will be eager to sell their
cars on the open market
Owners of good cars will not
Over time this will exert downwards pressure
on price and eventually only lemons will be
supplied
Trade in good cars will disappear
Akerlof’s Market for Lemons
Trade between family & friends
The importance of guarantees
Ex-ante monitoring expenditure by the
potential buyer – e.g. A.A. checks
Reputation of dealers
Hidden Information in
Organizations
Consider an employee applying for a job
elsewhere in the same company
Requires a reference from current ‘boss’ who has
the ‘best’ information
Reference writer will highly praise bad
employees to get rid of them
Reference writer will be lukewarm about good
employees to keep them
Reducing the Impact of Hidden
Information
Market Segmentation
Self-selection
Increase Monitoring
Forced risk pooling
Internalization
Hidden Action (Moral Hazard)
Having entered into a contract one party is
unable to observe the behaviour of the other
party who may then have an incentive to
engage in post-contract opportunism
In Markets - Insurance
In Organizations - Shirking
Reducing the Impact of Hidden
Action
Monitoring
Incentive Pay
