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Unformatted text preview: Lecture 33: Asymmetric Information. c & 2008 Je/rey A. Miron Outline 1. Introduction 2. The Market for Lemons 3. Quality Choice 4. Adverse Selection 5. Moral Hazard 6. Signaling 7. Incentives 8. Asymmetric Information 1 Introduction Much of the analysis we have presented in this course assumes that economic decision- making occurs in an environment of full information. We discussed one signi&cant exceptionconsumption and portfolio choices under uncertaintybut overall we have maintained that consumers and &rms know all the relevant prices, incomes, con- straints, and so on when they make decisions. This assumption is inaccurate in many settings. Whether it matters a lot or a little is more subtle. This lecture addresses some aspects of that question. As a &rst step in considering asymmetric information, note that uncertainty can change economic decision-making for roughly one of two reasons. 1 First, as we saw in earlier lectures about consumer choice, the presence of uncer- tainty a/ects consumer decisions whenever utility functions are not linear; that is, whenever consumers exhibit risk-aversion or risk-loving. In the special case where consumers care only about average consumption or expected returns, uncertainty becomes irrelevant, but this is rarely a plausible assumption if the amount of uncer- tainty is substantial. Second, as we will discuss in this lecture, uncertainty can have a dramatic e/ect on economic outcomes when it is asymmetric ; that is, when one side of a market has substantially better information about relevant economic variables than the other side. This assumption seems natural in a large number of real life economic settings. In particular, it seems natural to assume that, in many instances, the purchasers of a good have less information about its characteristics or quality than the sellers. This can apply when consumers are the purchasers, especially when buying new or relatively complicated goods (e.g., health care, cars, houses). It can also apply when &rms are the purchasers, as in the decision to hire employees whose productivity is not readily observeable. One important aspect of this discussion of markets with asymmetric information is that, as with externalities, the presumption of market e ciency does not apply. This is not to say all such situations result in Pareto ine ciencies or that particular interventions necessarily do more good than harm. But the possibility of welfare- enhancing intervention cannot be dismissed in this economic setting. So, this lecture provides an introduction to the economics of asymmetric infor- mation. We can only scratch the surface of this ltopic, unfortunately. Introducing information, especially asymmetric information, makes models complicated, and it opens the door to a large multiplicity of models since there are many ways to model uncertainty. This lecture will try to highlight the key issues that arise under asym- metric information....
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- Fall '09