Information Economics: Adverse Selection Notes

Information Economics: Adverse Selection

Introduction

  • Adverse Selection (AS) occurs when one party has more information before signing a contract that the other party cares about.
  • Example: A worker knows how talented they are, but the principal (employer) doesn't. The principal would like to hire a talented worker.
  • The informed party (agent) may lie to profit from their private information; the uninformed party (principal) will try to mitigate this information disadvantage.
  • This can lead to inefficiencies, and the goal is to characterize the optimal contract under AS (the second best solution).
  • In reality, both adverse selection and moral hazard can be present, but for simplicity, they are often studied separately.

Introduction (2)

  • Examples of Adverse Selection:
    • Health (medical insurance market)
    • Labor markets
    • Regulated firm knows more about its costs and market conditions
    • Car quality (second-hand market)
  • Principal will try to reduce informational disadvantage, creating a situation for the agent to reveal his private information

The Market for Lemons

  • Model introduced by Akerlof (1970) to describe adverse selection.
  • Considers a used car market where car quality q is uniformly distributed on (0, a).
  • A seller values a car of quality q at q, while a buyer values it at bq, where b > 1.
  • With perfect information, each car would be sold at a price p(q) \in [q, bq] leading to a separate market for each quality level.

The Market for Lemons: Asymmetric Information

  • When only sellers know the quality of their cars, the price cannot depend on q.
  • The price cannot exceed a/2, the average quality of all used cars.
  • Only sellers with cars of quality q \leq p would consider selling, leading to adverse selection.
  • The average quality of cars offered for sale becomes p/2, not a/2.
  • If b \geq 2, buyers will buy these cars. However, if b < 2, supply and demand may never meet.
  • As the price decreases, only the worst cars remain in the market, causing demand to fall with the price.
  • Removing asymmetric information (e.g., through reputation systems like Airbnb, eBay, Wallapop) can create a market that wouldn't otherwise exist.

Adverse Selection in the Labor Market

  • Firms want to hire hard-working workers, but workers have better knowledge of their work ethic.
  • With perfect information, firms would offer different contracts to hard-working and lazy workers, with corresponding pay.
  • Firms can offer multiple contracts designed to encourage workers to self-select into the contract that suits their type.
  • This section will study how firms offer contracts to agents of different types.

The Model

  • Similar to models for moral hazard.
  • An agent exerts effort a, resulting in a deterministic output \pi(a).
  • The principal offers a contract specifying the required effort and wage w.
  • Effort is costly: cost is c(a) for the