there is a choice between being a uniform price (i.e. winners all pay the same amount), or
price discrimination (i.e. winners pay different amounts). Auction theory is popular
because it demonstrates how blackboard theory can translate into real world outcomes.
When the UK government wanted to auction off 3G licences they turned to a group of
academic economists. By understanding auction theory, and testing it in a classroom with
students, Ken Binmore and Paul Klemperer made their recommendations. The results
were astounding. It raised £22.5bn, which equates to around 2.5% of GNP.
a discovery mechanism as much as an allocation one.
3.3 INFORMATION ECONOMICS
This may all work in theory, but how do markets function in practice? Even if prices are
allowed to adjust, are markets perfect? Although it's true that economists tend to put a lot
of trust in the ability of markets to find equilibrium, economists also spend a lot of time
considering instances where they fail. There are a number of examples of ‘market
failure’, one of which is the concept of
. This occurs when
actors on one side of the market have better quality information than those on the other.
If we're buying and selling eggs, information is reasonably symmetrical. An egg is an egg.
But in some situations it's hard to know the exact characteristics. Imagine a company that
offered to pay £200 to anyone that had a skiing accident. Here the information is highly
asymmetric, because you are likely to know whether you're a safe or reckless skier. But
this isn't obvious to the company. You have better quality information than they do. We
can see two implications of asymmetric information.
In our example, the skiers most likely to buy the product are the most accident-
prone. If the odds of an accident are calculated across all skiers, the company will
suffer from a selection bias. The insurance is attracting the ‘wrong’ kind of person.
Even if the skier is a reasonably safe one, if they buy the insurance it will affect their
incentive to ski safely. At the margin the insurance will encourage them to be more
risky, and therefore make it more likely that they have an accident. It's a bit like
wearing a helmet – the insurance changes people's incentives and therefore changes