2305 AAEC Fundamentals of Ag Economics Chapter 14 Incomplete Information
Incomplete Information
In our previous discussion of production and consumption we made the assumption of perfect information That is, we assumed that every agent knows everything about the goods being produced and consumed How realistic is this assumption?
Objectives
We want to answer the following questions:
How
does imperfect information affect production and consumption decisions? How does imperfect information affect the operation of markets?
Is this important?
2001
Nobel Prize was awarded to 3 researchers who pioneered work in asymmetric information
Asymmetric Information Examples
Why do people eat at McDonalds? Would you consider finding a good mechanic an easy or difficult task? Why do you pay an insurance deductible or co-pay?
The Market for Lemons
Assume that all new cars are either good or defective
Buyers
know quality only after purchasing
Any owner of a new car can sell on the used car market
Defective
and good cars should sell for the same equilibrium price Price of used cars is less than price of new cars Otherwise a person could costlessly buy a new car, find it defective, sell it for the same price and try another new car
The Market for Lemons
How
will the market for used cars develop?
Will
there be more lemons than the new car market? Will there be any good, used cars for sale? Can sellers of good, used cars signal their high quality?
The Market for Lemons
In a perfect information market:
GoodCars
S Price
Price
Lemons
D
S
D Quantity Quantity
The Market for Lemons
In an asymmetric information market:
GoodCars
S Price
Price
Lemons
D D1
S D1 D Quantity Quantity
The Market for Lemons
What is the market price of a new car if
the
price of a used car were $4500, the value of a new car is $12000, and the probability of a lemon is 5%?
Price is equal to expected value of a new car
Expected
value is sum of possible values, multiplied by respective probabilities .05*4500 + .95*12000 = $11625
What if probability of a lemon is 15%?
.15*4500
+ .85*12000 = $10875
Market Signaling
Sellers may engage in market signaling
Market
signaling any is attempt to convey information about the quality of the good being sold
Why would a seller wish to send such a signal?
What
if sending the signal was costly for the seller?
Market Signaling
Consider the example of a firm hiring employees The firm wishes to pay employees wages equal to their marginal productivity Marginal productivity of a prospective employee is difficult to observe
The
workers themselves know their own productivity and effort levels
How can a firm identify high-productivity or high-ability workers?
Market Signaling
Firms frequently use education as a signal of productivity
Even
if the degree is not immediately relevant to the job being performed
Schooling may impart information and skills that help people work more effectively But there is more
Market Signaling
Assume there are two types of workers
High-productivity
workers: productivity = 2 Low-productivity workers: productivity = 1
A firm that pays wage w will receive net profits of 2 w or 1 w The firm would like to offer w = 2 to highproductivity workers and w = 1 to lowproductivity workers
But
the firm cannot distinguish between them
Market Signaling
Workers, before they enter labor market, may earn a degree A degree takes time and money
y
is time required to earn degree Cost of education for low-productivity workers equals y Cost of education for high-productivity workers equals y/2
Employers accept that the signal conveys some information
(but
the education does not increase productivity)
Market Signaling
Potential employers assume that any applicant with education y greater than y* is high-productivity
Applicants
with education y > y* receive wage =
2 Applicants with education y < y* receive wage = 1
Given this structure, would an applicant ever have y < y* education? Candidates would only have y = 0 or y = y*
Market Signaling
So what level y* should the employer choose?
Employers
will be happy if low-productivity workers choose y = 0 and high-productivity workers choose y = y* For low-productivity workers it must be that
1 0 > 2 y*
For
high-productivity workers it must be that
So
1 < y* < 2