Markets with Asymmetric Information

- For more than two decades, research on incentives and market equilibrium in sit- uations with asymmetric information has been a proliÞc part of economic theory.
- The theory of markets with asymmetric information rests Þrmly on the work of three researchers: George Akerlof (University of California, Berkeley), Michael Spence (Stanford University) and Joseph Stiglitz (Columbia Uni- versity).
- This year’s laureates showed that these — and many other — phenomena can be understood by augmenting the theory with the same realistic assumption: one side of the market has better information than the other.
- the CEO and board of a Þrm know more than the shareholders about the proÞtability of the Þrm.
- Markets with Asymmetric Information 2.
- More speciÞcally, the contributions of the prizewinners may be summarized as fol- lows.
- When lenders or car buyers have imperfect information, borrowers with weak repayment prospects or sellers of low-quality cars may thus crowd out everyone else from their side of the market, stißing mutually advantageous transactions.
- Akerlof, Spence and Stiglitz’s analyses form the core of modern information eco- nomics.
- Sections 1 though 3 below give a brief account of the most fundamental contribu- tions by the laureates.
- Akerlof’s article, “The Market for Lemons: Quality Uncertainty and the Market Mechanism” (Akerlof, 1970), is probably the single most important contribution to the literature on economics of information.
- Those terms say more about the causes of the phenomenon whereas “adverse selection” emphasizes its consequences..
- sellers are better informed than buyers about the quality of the good.
- Each buyer is potentially interested in purchasing one unit, but cannot observe the difference between the two qualities at the time of the purchase.
- All buyers have the same valuation of the two qualities: one unit of low quality is worth w L dollars to the buyer, while one high-quality unit is worth w H >.
- Each seller knows the quality of the units he sells, and values low-quality units at v L <.
- But if the markets are not regulated and buyers cannot observe product quality, unscrupulous sellers of low-quality products would choose to trade on the market for high quality.
- 3 Classical economic analysis disregarding asymmetric information would misleadingly predict that goods of both qualities would be sold on the market, at a price close to the consumers’ average valuation..
- Markets with Asymmetric Information 4.
- In a later article, “The Economics of Caste and the Rat Race and Other Woeful Tales” (Akerlof, 1976), Akerlof enters into a more thorough discussion of the signif- icance of informational asymmetries in widely differing contexts, such as the caste system, factory working conditions and sharecropping.
- In the case of sharecropping, where tenancy is repaid by a Þxed share of the harvest, a tenant’s volume of production acts as an indicator of his work effort on the farm.
- On the assembly line in a fac- tory, the speed of the conveyor belt acts as an indicator of the workers’ ability, and can therefore be used as an instrument to distinguish between workers of different abilities..
- In this context, signaling refers to observable actions taken by economic agents to convince the opposite party of the value or quality of their products.
- The productivity of low-productivity workers, w L , is below that of high- productivity workers, w H and the population shares of the two groups are λ and 1 − λ, respectively.
- Education is measured on a continuous scale, and the necessary cost — in terms of effort, expenses or time — to reach each level is lower for high-productivity individuals.
- Instead of a market failure, where high-productivity individuals remain outside of the market (e.g., by moving away or setting up their own business), these workers participate in the labor market and acquire a costly education solely to distinguish themselves from low-productivity job applicants..
- 6 The crucial assumption that more productive applicants Þnd it sufficiently less costly to acquire an education — the ßatter indifference curve in Figure 1 — is closely related to Mirrlees’ (1971) so-called single-crossing condition.
- Markets with Asymmetric Information 7.
- In particular, various reÞnements of the Nash equilibrium concept have been developed to discriminate between the many signaling equilibria in Spence’s model.
- During the period he was one of the pioneers in the wave of game-theory inspired work within the so-called new industrial organization theory.
- Stiglitz’s classical article with Rothschild on adverse selection, “Equilibrium in Com- petitive Insurance Markets: An Essay on the Economics of Imperfect Information”.
- 7 Rothschild and Stiglitz ask what uninformed agents can do to improve their outcome in a market with asymmetric information.
- Rothschild and Stiglitz’s model may be illustrated by means of a simple example..
- 9 Stiglitz (1977) provides an analysis of the monopoly case..
- Markets with Asymmetric Information 9.
- Rothschild and Stiglitz’s article has been very inßuential.
- Two papers coauthored by Stiglitz and Weiss analyze credit markets with asymmetric information.
- Stiglitz’s work with Grossman (Grossman and Stiglitz, 1980) analyzes the hypoth- esis of efficiency on Þnancial markets.
- In Shapiro and Stiglitz’s model, an employer is as- sumed to carry out random surveys among his employees to observe their work effort..
- Shapiro and Stiglitz’s model is an important ingredient in modern labor and macroeconomics..
- Stiglitz is also one of the founders of modern development economics.
- Stiglitz (1974a) and Akerlof (1976) both attempted to explain this relation, in terms of asymmetric information between the two parties.
- Since the landowner usually can- not observe tenants’ work effort, an optimal contract strikes a balance between risk sharing and incentives, letting the tenants assume some share of the risk..
- In addition to his work on the economics of information, Stiglitz has made sig- niÞcant contributions to public economics, especially the theory of optimal taxation (see e.g., Stiglitz and Dasgupta, 1971), industrial organization (see e.g., Dixit and Stiglitz, 1977), and the economics of natural resources (see e.g., Stiglitz 1974b and Dasgupta and Stiglitz, 1980)..
- Markets with Asymmetric Information 11.
- Akerlof, Spence and Stiglitz’s analyses of markets and information asymmetries are fundamental to modern microeconomic theory.
- This section offers a selection of such applications from recent research and a brief discus- sion of some empirical tests of the models..
- Riley’s idea is that signaling should be most important in those sectors of the economy where worker productivity is difficult to measure.
- Markets with Asymmetric Information 13.
- The model predicts that the wage effect of education is independent of the length of time a worker has been on the labor market, whereas the wage effect of constant, unob- servable characteristics, which are positively correlated with worker ability, increases with the time a worker has been employed.
- Acemoglu and Pischke (1998) show that asymmetric information about worker ability can explain on-the-job training in Þrms.
- Informational asymmetries concern- ing a trained worker’s productivity generate a monopsony (a buyer monopoly) on the local labor market, implying that the Þrm can successively pay for the training by a wage which falls short of the competitive wage.
- Other attempts to test for the predicted effects of asymmetric information have produced ambiguous results.
- Prime examples are Akerlof’s lemons model and Stiglitz’s sharecropping model.
- Extensions of the latter e.g., have been used to explain institutional relationships between landowners and tenants, such as why landowners often grant credit to tenants (it has positive incentive effects on work effort).
- Basu (1997) is an example of a modern advanced textbook in development economics that builds heavily on the economics of information..
- 14 A direct test carried out by Bond (1982) on data from a market for second-hand small trucks does not lend support to the asymmetric information hypothesis.
- Riley (2001) gives a detailed survey of economic analyses of markets with asymmetric information.
- Gibbons (1992) offers an accessible introduction to game-theoretic modeling of asymmetric information..
- Markets with Asymmetric Information 15.
- Pischke (1998): “Why do Firms Train? Theory and Evi- dence”, Quarterly Journal of Economics .
- (1970): “The Market for Lemons: Quality Uncertainty and the Mar- ket Mechanism”, Quarterly Journal of Economics .
- (1976): “The Economics of Caste and of the Rat Race and other Woeful Tales”, Quarterly Journal of Economics .
- (1980): “A Theory of Social Customs of which Unemployment May be One Consequence”, Quarterly Journal of Economics .
- Yellen (1990): “The Fair Wage Hypothesis and Unemploy- ment”, Quarterly Journal of Economics .
- (1972): “The Value of and Demand for Information”, in McGuire, C..
- (1973): “Higher Education as a Filter”, Journal of Public Economics .
- (2001): “Human Capital versus Signaling Models: University Access and High School Dropouts”, Journal of Political Economy .
- (1982): “A Direct Test of the Lemons Model: The Market for Used Pickup Trucks”, American Economic Review .
- Stiglitz (1982): “Sharecropping and the Interlinking of Labor Markets”, American Economic Review .
- Kreps (1987): “Signaling Games and Stable Equilibria”, Quar- terly Journal of Economics .
- Salani´e (2000): “Testing for Asymmetric Information in Insurance Markets”, Journal of Political Economy .
- (1983): “Adverse Selection and Statistical Discrimination: An Analy- sis of Canadian Automobile Insurance”, Journal of Public Economics .
- (1992): “Testing for Asymmetric Information in Canadian Automobile Insurance”, in G.
- Stiglitz (1980): “Uncertainty, Industrial Structure, and the Speed of R&D”, Bell Journal of Economics 11, 1-28..
- Stiglitz (1977): “Monopolistic Competition and Optimal Product Diversity”, American Economic Review .
- Gibbons (1996): “Learning and Wage Dynamics”, Quarterly Journal of Economics .
- Schmidt (1999): “A Theory of Fairness, Competition and Co- operation”, Quarterly Journal of Economics .
- Ad- vances in Economic Theory, Eigth World Congress of the Econometric Society, Cambridge University Press (Cambridge, UK)..
- Markets with Asymmetric Information 17.
- Katz (1991): “Layoffs and Lemons”, Journal of Labor Eco- nomics .
- Stiglitz (1980): “On the Impossibility of Informationally Efficient Markets”, American Economic Review .
- Williams (1985): “Dividends, Dilution and Taxes: A Signalling Equilibrium”, Journal of Finance .
- Kropp (1986), “Human Capital versus Sorting: The Effects of Compulsory Attendance Laws, Quarterly Journal of Economics .
- (1959): “Remarks on the Economics of Information”, Contribu- tions to ScientiÞc Research in Management, Western Data Processing Center, University of California, Los Angeles, 79-98..
- Roberts (1986): “Price and Advertising Signals of Product Quality”, Journal of Political Economy .
- Oster (1987): “Job Discrimination, Market Forces, and the Invisibility Hypothesis”, Quarterly Journal of Economics .
- (1971): “An Exploration in the Theory of Optimum Income Taxa- tion”, Review of Economic Studies .
- Majluf (1984): “Corporate Financing and Investment Decisions when Firms Have Information that Investors Do Not Have”, Journal of Financial Economics .
- (1974): “Advertising as Information”, Journal of Political Economy .
- Snow (1994): “Evidence on Adverse Selection: Equilibrium Signalling and Cross-Subsidization in the Insurance Market”, Journal of Political Economy .
- (1975): “Competitive Signalling”, Journal of Economic Theory .
- (1979): “Testing the Educational Screening Hypothesis”, Journal of Political Economy .
- (2001): “Silver Signals: Twenty-Five Years of Screening and Signaling”, Journal of Economic Literature .
- Stiglitz (1976): “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information”, Quarterly Jour- nal of Economics .
- Stiglitz (1984): “Equilibrium Unemployment as a Worker Discipline Device”, American Economic Review .
- (1973): “Job Market Signalling”, Quarterly Journal of Economics .
- (1977): “Entry, Capacity, Investment and Oligopolistic Pricing”, Bell Journal of Economics .
- Markets with Asymmetric Information 19.
- Weiss (1981): “Credit Rationing in Markets with Imperfect Information”, American Economic Review .
- (1977): “A Model of Insurance Markets with Incomplete Information”, Journal of Economic Theory

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