Lec14-Private_Info_Adverse_Selection_Market_Failure

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Lecture Note #14 °Private Information, Adverse Selection and Market Failure David Autor 14.03, Microeconomic Theory and Public Policy, Fall 2005 1 Private Information, Adverse Selection and Market Failure ° We began the semester by studying decision-making in a setting with complete informa- tion and uncertainty. ° We extended the model to a setting with uncertainty through the VNM Expected Utility framework. In this model, an agent faces a set of known risks characterized by a prob- ability distribution over a set of outcomes. In this model, uncertainty is an exogenous characteristic of the decision-making environment. That is, the only sense in which infor- mation is ± imperfect²or ± incomplete²is that the state of nature, a random variable, has not yet been realized. ° But of course, where there is imperfect information, there is an incentive for agents to engage in strategic behavior. For example, if I²m selling you a product, and you know the distribution of product quality that I possess but not the quality of the individual product I will sell you, how much should you be willing to pay? The intuitive answer might be the expected value of the product, or the certainty equivalent value of the expected utility value of this lottery. ° But, as we will discuss in this lecture, this answer is incorrect. The problem here is that, in addition to exogenous uncertainty, there is endogenous decision-making by market participants. The choice of what product I sell you may depend on what the price that you o/er me. But then the price that you o/er me may depend on what product you think ll sell you at the price you o/er. The equilibrium outcome where our expectations are aligned³ that is, you get what you wanted at the price you o/er³ may be quite ine¢ cient. 1
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A bit of background: ° It used to be thought that markets for information are well-behaved, like markets for other goods and services. One could optimally decide how much information to buy, and hence equate the marginal returns to information purchases with the marginal returns to all other goods. ° In the 1970s, economists were brought to reevaluate this belief by a series of seminal papers by Akerlof, Stiglitz, and Spence. These economists all went on to share the 2001 Nobel for their work on the economics of information. We will study all three papers. (The coauthor on the Stiglitz paper, Michael Rothschild, did not receive the Nobel.) ° Information is not a standard market good: ° Non-rivalrous (no marginal cost to each person knowing it) ° Extremely durable (not consumed) ° Not a typical experience good where you can ±try before you buy.² Cannot readily allow you to ±sample²information without actually giving you information. ° Unlike other goods (or their attributes), information is extremely di¢ cult to measure, observe, verify.
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