Varian, Intermediate Microeconomics chs.12&34
Gravelle & Rees, ch.22
Kreps, A course in Microeconoic Theory chs.16&17
Akerlof (1970) ŒThe market for lemons.¹ Quartely Journal of Economics. Reprinted in Akerlof An economic theorist¹s book of tales, and in Diamond & Rothschild Uncertainty in Economics
Rothschild & Stiglitz (1976) ŒEquilibrium in competitive insurance markets: An essay in the economics of imperfect information.¹ Quartely Journal of Economics. Reprinted in Diamond & Rothschild. Not the easiest paper, so don¹t worry about understanding every line!
You may also want to look at:
J. Mirrlees (1997) ŒNobel Prize Lecture: The Economics of Carrots and Sticks.¹ Economic Journal.
1. “Imperfect and asymmetric information can lead to drastic differences in the nature of market equilibrium.” Discuss.
Market equilibrium occurs where the demand equals supply. In a competitive market there is normally only one stable equilibrium, which is obtained by the price system. However, under uncertainty there may be no market for some goods at all, although demand and supply are there. Furthermore, sometimes quantity rationing is used alongside the price system to reach equilibrium.
There is no single theory of asymmetric information, more like cases where information differences have been applied leading to different results than obtained from symmetric information. I will first explain these cases in symmetric information, look at the results and then go on to discuss how asymmetric information affects them.
With uncertainty instead of having a set of utility curves, individuals will have probabilities of obtaining different sets of utility. The analysis is very similar to the one with no uncertainty, because the individuals will essentially be using the combined utility curve, where the utility is obtained by multiplying the probabilities of different states with the utilities they give.
An interesting feature of the symmetric uncertainty arises from the fact that not all individuals are risk neutral. Thus there can be institutions set up (insurance companies) that pool the risk of individuals and offer them the average return, instead of just probabilities of different returns. This will make one outcome certain and increase the utility of individuals.
When information is asymmetric that means that one party knows what other party does not. For example when selling a car, the seller knows the quality and the buyer does not. Number of problems arises.
Adverse selection means that bad goods drive out good ones. Everyone would like to sell a bad quality car and buy a good quality one. Presenting just the final result, there will always be market for the bad quality product, however, not necessarily for the good quality one. Adverse section is also called the hidden information problem.
Moral hazard is the other situation that can give rise to a different equilibrium. It is basically an example of a situation where an action is hidden, similar to a principal agent problem.
An example of a moral hazard is the insurance market. When one gets 100% insured they have an incentive not to take care of the stuff anymore. Thus insurance companies will have to insure less than 100% of the value, although this would give people highest utility. There is an example where quantity has to be set as well as the price.
This topic can be further extended to show that there can be no pooling equilibrium when asymmetric information is present. This means that when there are two types of goods there will be two different markets, not the same market with probability of getting a lemon. Further extensions include the efficiency wage argument in which the worker will be paid more than his reservation wage to make him put more effort in, that is not directly observable, and only outcome is. The result from that analysis is that the extra wage will be higher, the smaller the difference between the observable outcomes of effort and no effort. One can get a second best equilibrium state, the incentive-compatible equilibrium, because the first best is too expensive to provide incentives for.
Furthermore, there is extensive signalling theory developed that shows how people actually acquire the signals that show whether they put effort in or not. The signal is only worth-while getting when some people obtain it cheaper than others (clever people with education), and it is actually a wastage of resources.
2. “There is a trade-off between providing insurance against risk and providing incentives.” Discuss.
It is a very simple moral hazard trade-off. When one insures all risk, there is no incentive to take care of the thing. On the other hand, when no insurance is provided, people will be subjected to unnecessary risks and they would be prepared to get a lower expected income, when it is certain (that would give them higher utility).
However, one can set up a contract that both insures and provides the right incentives. When, for example, monitoring can be done as to whether people take care of their belongings or not, the incentives are set so as to ensure sufficient care. However, these contracts can get to complicated and there is a further theory that looks at the simplest reasonable contract.