Chapter summary

Information is the key to the organisation of successful economic activity. If one party to a trade has more information than another, then the exploitation of this information will be to their advantage. Eventually, though, the less-informed party will realise their disadvantage and trade may cease – a situation that will be to the detriment of both parties. This does not imply that perfect information is necessary for efficiency. Indeed, the essence of a stock market is the imperfect information about future profitability of firms but such a market can reach an efficient equilibrium. What is necessary for efficiency is symmetric information, meaning that no party has an informational advantage. When this condition is not met, there is asymmetric information and inefficiency will result. This chapter explores the consequences of asymmetric information and describes the inefficiencies that arise. Possible forms of government intervention are analysed. Asymmetric information can also arise between the government and the consumers and firms in the economy. When it does, it restricts the policies that the government can implement. Some aspects of how this affects the effectiveness of the government will be covered in this chapter, others will become apparent in later chapters.

9.1 Hidden knowledge and hidden action

There are two basic forms of asymmetric information that can be distinguished. Hidden knowledge is when one party has more information than another on the quality of a traded good. Hidden action is when one party can affect the quality of a traded good by some action and this action cannot be observed by the other party.

Hidden knowledge leads to the adverse selection problem.

Hidden actions result in the moral hazard problem. This refers to the difficulties of designing incentive schemes that ensure the right actions are taken.

• Hidden knowledge and adverse selection
• Hidden action and moral hazard

9.2 Market unravelling

Asymmetric information can lead to a breakdown in trade as the less-informed realise that they are not gaining the benefits expected. The basic conclusion to emerge is that in equilibrium some consumers do not purchase insurance even though they could profitably be sold it by insurance companies.

This process of **market unravelling** is where only a small fraction of the potential consumers are actually served in equilibrium. The level of the premium is too high for the low risk to find it worthwhile to take out the insurance. This outcome is clearly inefficient since the first-best outcome requires insurance for all consumers.

Inefficiency arises because one party cannot observe probabilities. This is an example of the mechanism of **adverse selection** in which the bad types always find it profitable to enter the market at the expense of the good.

In this situation a policy that can make many consumers better-off is compulsory insurance based on the average risk. With compulsory insurance the premium will be pi = 1/2 which is less than pi ˆ . This lowers the average premium, thus benefiting all of those who would be willing to pay a premium in excess of 1/2. The imposition of compulsory insurance may seem a very strong policy since there are few circumstances in which consumers are forced by the government to make specific purchases. But it is the policy actually used for many insurance markets. For instance, both automobile insurance and employee protection insurance are compulsory.

• Risk-type unobserved (asymmetric information)
• Low-risk priced out of market (adverse selection)
• Compulsory insurance raises welfare

9.3 Adverse selection

If consumers differ in the probability of having an accident, insurance companies will want to distinguish between the high risk and low risk. Doing so allows them to offer insurance policies for each type and avoid the pooling of risks that causes market unravelling. To achieve this, insurance companies have to offer different contracts designed so that each risk type self-selects the contract designed for it.

An equilibrium where different types purchase different contracts is called a separating equilibrium. This should be contrasted to the pooling equilibrium of the previous section in which all consumers purchasing insurance bought the same contract.

Now consider the possibility of a separating equilibrium. Any separating equilibrium must offer the high-risk consumers full insurance. The contract offered to the low-risk consumers has to be restricted not to be better for the high-risk than the full-insurance contract. Applying this reasoning, the only potential separating equilibrium is the pair of contracts {a, b}. Whether these contracts form an equilibrium depends upon whether there is a pooling contract that is preferred by both types.

In conclusion, there is no pooling equilibrium in this model of the insurance market. There may be a separating equilibrium, but this depends upon the population proportions. When there is no separating equilibrium, there is no equilibrium at all. Asymmetric information either causes inefficiency by leading to a separating equilibrium in which the low risk have too little insurance cover or it results in there being no equilibrium.

In the latter case, we cannot predict what the outcome will be. Government intervention in this insurance market is limited by the same information restriction that affects firms: they cannot tell who is low risk or high risk directly but can only make inferences from their choices.

This has the consequence that it restricts policy intervention to be based on insurance policies, not individuals. Even under these restrictions, the government can achieve a Pareto improvement by imposing a cross-subsidy from low-risks to high-risks. It does this by subsidising the premium of the
low-risk and taxing the premium of the high-risk. This equilibrium cannot be achieved by the insurance companies because it would require them all to act simultaneously. This is an example of a coordination failure which prevents the attainment of a better outcome.

• Self-selection of contracts
• Separating and pooling equilibrium
• No pooling equilibrium, possibly no separating equilibrium

9.4 Signalling

At the heart of asymmetric information is the inability to distinguish the good from the bad. This is to the detriment of both the seller of a good article, who fails to obtain its true value, and to the purchaser who would rather pay a higher price for something that is known to be good. This situation would be improved if the seller could convey some information that convinces the purchaser of the quality of the product. Such information, generally termed signals, can be mutually beneficial. For a signal to work it must be verifiable by the purchaser and it must be credible. The signal must also be costly for the seller to obtain and the cost must differ between various qualities of seller. Something which is either costlessly obtainable by both the sellers of low and high quality or equally costly cannot have any value in distinguishing between them.

Hence when there are sufficiently many high productivity workers, so that the average wage is close to the high productivity level, the separating equilibrium is Pareto-dominated by the pooling equilibrium. In these cases, signalling is individually rational but socially unproductive. If the government were to intervene in this economy, it has two basic policy options. The first is to allow signalling to occur but to place an upper limit on the level of education. It might choose to do this in those cases where the pooling equilibrium does not Pareto dominate the separating equilibrium. There is though, one problem with banning signalling and enforcing a pooling equilibrium: the pooling equilibrium requires the firms to believe that all workers have the same ability. If the firms were to ‘test’ this belief by offering a higher wage for a higher level of education, they would discover that the belief was incorrect.

The basic problem for the government in responding to problems of this form is that it does not have a natural informational advantage over the private agents. In the model of education there is no reason to suppose the government is any more able to tell the low-productivity workers from the high-productivity (in fact, there is every reason to suspect that the firms would be better equipped to do this). Faced with these kinds of problems, the government may have little to offer.

• A signal transmits information
• Signals need to be credible
• A range of Pareto-ranked equilibria

9.5 Moral hazard (hidden action)

A moral hazard problem arises when an agent can affect the ‘quality’ of a traded good or contract variable by some action which is not observed by other agents.

The government can intervene in this market by employing a tax-subsidy policy that encourages (indirectly) high prevention effort or discourages low prevention effort. The main idea is to tax (respectively, subsidise) the goods whose consumption is negatively (respectively, positively) related with prevention efforts. A tax on alcohol and tobacco is a good example in the case of health insurance. The net effect of such market intervention is to provide an incentive to make an effort, achieving a Pareto-improvement.

• Effort at accident prevention is unobserved
• Insurance is offered on incorrect terms
• Insurance cover is limited in equilibrium

Reading: Jean Hindriks and Gareth D. Myles (2004), Intermediate Public Economics

Chapter 12 Asymmetric Information

"In economics asymmetric information arises when the two sides of the market have different information about the goods and services being traded. In particular, sellers typically know more about what they are selling than buyers do. This can lead to adverse selection where bad-quality goods drive out good-quality goods, at least if other actions are not taken. Adverse selection is the process by which buyers or sellers with “unfavorable” traits are more likely to participate in the exchange. Adverse selection is important in economics because it often eliminates exchange possibilities that would be beneficial to both consumers and sellers alike. There might seem some easy way to resolve the problem of information asymmetry: let everyone tells what he knows. Unfortu- nately, individuals do not necessarily have the incentive to tell the truth" p257

"Information imperfections are pervasive in the economy and in some sense it is an essential feature of a market economy that different people know different things. While such information asymmetries inevitably arise, the extent to which they do so and their consequences depend on how the market is organized, and the anticipation that they will arise affects market behavior." p257-258

"One fundamental lesson of information imperfections is that actions convey information... The process by which individuals reveal information about themselves through the choices that they make is called self-selection." p258

"In equilibrium both sides of the market are aware of the informational consequences of their actions. In the case where the insurance company or employer takes the initiatives, self-selection is the main screening device. In the case where the insured, or the employee, takes the initiative to identify himself as a better type, then it is usually considered as signalling device. So the differences between screening and signalling lies in whether the informed or uninformed side of the market moves first." p258

"The fact that actions convey information affects equilibrium outcomes in a profound way. Since quality increases with price in adverse selection models, it may be profitable to pay a price in excess of the market clearing price... There may exist multiple equilibria. Two forms of
equilibria are possible: pooling equilibria in which the market cannot distinguish among the types, and separating equilibria in which the different types separate out by taking different actions. On the other hand, under plausible conditions, equilibrium might not exist (in particular if the cost of separation is to great)." p259

"These asymmetries of information about actions are as important as the situations of hidden knowledge. They lead to what is referred to
as the moral hazard problem. This term originates from the insurance industry which recognized early that more insurance reduces precaution from insured (and not taking appropriate risk was viewed to be immoral, hence the name)." p259

"Hidden knowledge refers to a situation in which one party has more information than the other party on the quality (or “type”) of a traded good or contract variable. Hidden action is when one party can affect the “quality” of a traded good or contract variable by some action and this action cannot be observed by the other party." p260

"Hidden knowledge leads to the adverse selection problem... From hidden actions arises the moral hazard problem." p260-261

".. asymmetric information could lead to a break- down in trade as the less-informed party began to realize that the less desirable potential partners are those who are more willing to exchange" p262

"There is a simple way the government can avoid the adverse selection process by which only the worst risks purchase private: it is by forcing all individuals to purchase the insurance. Compulsory insurance is then a policy that can make many consumers better-off." p263

"The mechanism that can be used by the insurance companies is to offer a menu of different contracts designed so that each risk type self-selects the
contract designed for it. By self-select we mean that the consumers find it in their own interest to select the contract aimed at them. As we will show, self-selection will involve the bad risks being offered full insurance coverage at a high premium while the low risks are offered partial coverage at a low premium requiring them to bear part of the loss. The portion they have to bear consists of a deductible (an initial amount of the loss) and coinsurance (an extra fraction of the loss beyond the deductible). An equilibrium like this where different types purchase different contracts is called a separating equilibrium. This should be contrasted to the pooling equilibrium of the previous section in which all
consumers purchasing insurance purchased the same contract." p266

"Government intervention in this insurance market is limited by the same information restriction that affects firms: they cannot tell who is low risk or high risk directly but can only make inferences from their choices. This has the consequence that it restricts policy intervention to be based on the same information as the one available to the insurance companies. Even under these restrictions, the government can achieve a Pareto improvement by imposing a cross-subsidy from low-risks to high-risks. It does this by subsidizing the premium of the high-risk and taxing the premium of the low-risk. It can do that without observing risk by imposing a minimal coverage for all at the average risk premium." p271

"The fundamental feature at the heart of asymmetric information is the inability to distinguish the good from the bad. This is to the detriment of both the seller of a good article, who fails to obtain its true value, and to the purchaser who would rather pay a higher price for something that is known to be good." p272

"Warranties can also serve as signals of quality of durable goods because if a product is of higher quality it is less costly for the seller to offer a longer warranty on it. Such information, generally termed signals, can be mutually beneficial." p273

"To illustrate the consequences of signalling, we shall consider a model of productivity signalling in the labor market. The firms cannot directly observe a worker’s type before hiring, but high-productivity workers can signal their productivity by getting educated. Education itself does not alter productivity but it is costly to acquire. Firms can observe the level of education of a potential worker and condition their wage offer upon this. Hence, education is a signal. Investment in education will be worthwhile if it earns a higher wage." p274

"The market failure associated with moral hazard is very profound. The moral hazard problem arises from the non-observability of the level of care... Can the government improve efficiency by intervention when moral hazard is present? In answering this question it is important to specify what information is available to the government... The beneficial effects of government intervention stem from the government’s capacity to tax and subsidize." p286

"Economists do not expect private insurance market for health care to function well. Our previous discussion suggests that informational problems would leave the private provision of health insurance coverage incomplete and inefficient. The existence of asymmetric information between insurers and insured leads to adverse selection, which can result in the market break down, and the non-existence of certain types of insurance. The moral hazard problem can lead to incomplete insurance in the form of copayments and deductibles for those who have insurance. Another problem caused by the presence of moral hazard is that the insured who get sick will want to overconsume and doctors will want to oversupply health care since it is a third party who pays. It is not surprising, therefore, that the government may usefully intervene in the provision of health care." p287

"Government provision not only requires mandatory insurance to eliminate the adverse selection problem; but it also involves socializing insurance. Once insurance is compulsory and financed (at least partly) by taxation, redistributive consideration plays a central role to explain the extensive public provision of insurance. Government programmes which provide the same amount of public services to all households may still be redistributive. In fact, the amount of re-distribution depends on how the programmes are financed, and how valuable the services are to individuals with different income levels." p289

"First, a public health care programme offering services available to all financed by a proportional income tax will redistribute income form the rich to the poor... The second way redistribution occurs is from the healthy to the sick (or the young to the aged). Tax payments of any particular individual do not depend on that individual’s morbidity... The third way of redistribution is through opting out. Universal provision of health care by the government can redistribute welfare from the rich to the poor because the rich refuse the public health care and buy a higher quality private health services financed by private insurance. Fourth, a redistribution via health care is more effective to target some needy groups than redistribution in cash." p289-290