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Chapter 18
Asymmetric Information
Chapter Outline
18.1 Problems Due to Asymmetric Information
18.2 Responses to Adverse Selection
Controlling Opportunistic Behavior Through Universal Coverage
Equalizing Information
Screening
Application: Risky Hobbies
Signaling
18.3 How Ignorance About Quality Drives Out High-Quality Goods
Lemons Market with Fixed Quality
Market Equilibrium with Symmetric Information
Market Equilibrium with Asymmetric Information
Solved Problem 18.1
Lemons Market with Variable Quality
Solved Problem 18.2
Limiting Lemons
Laws to Prevent Opportunism
Consumer Screening
Application: Changing a Firm’s Name
Third-Party Comparisons
Standards and Certification
Signaling by Firms
Application: Adverse Selection on eBay Motors
18.4 Market Power from Price Ignorance
Tourist-Trap Model
When Price Is Not Competitive
Monopoly Price
Solved Problem 18.3
Advertising and Prices
18.5 Problems Arising from Ignorance When Hiring
Cheap Talk
Education as a Signal
Separating Equilibrium
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Pooling Equilibrium
Solved Problem 18.4
Unique Equilibrium or Multiple Equilibria
Efficiency
Screening in Hiring
Interviews and Tests
Statistical Discrimination
Teaching Tips
Chapter 18 presents a nice opportunity to analyze some very intriguing economic questions without much
need to run through a long series of mathematical relationships. Thus, it can serve very effectively as a
way to expose students who are either weak quantitatively or simply weary of optimization problems to
areas where there is current, interesting work being done. Topics addressed in this chapter are also of great
relevance today for consumers, given the changes in the health insurance industry and information
technology, especially the Internet.
If many of your students work full time, they will certainly be familiar with HMOs and the demise of full
indemnity coverage due to adverse selection problems. Because HMOs are the most cost–effective choice
for healthy individuals interested in low– or no–cost physical exams, baby care, and health club reimbursement,
and traditional indemnity plans typically offer better coverage for individuals who are in relatively poor
health, an adverse selection problem arises. As traditional plans become populated by individuals who are,
on average, sicker than the rest of the working population (upon which actuarial tables are based), premiums
must rise. The adverse selection problem then becomes even more severe as premiums rise. For this
reason, traditional indemnity plans are becoming cost prohibitive, and many employers are changing their
mix of offered health care plans.
When discussing asymmetric information and the costs of obtaining information, an interesting application
to discuss is the tourist-trap model (described in the text) in which all consumers end up paying the
monopoly price even if there are many souvenir shops. This example creates a good lead-in to the section
on advertising and prices. Students are likely to take a dim view of advertising by lawyers until you
discuss the price implications.
One of the most important topics in the chapter, especially if your program is labor- or industrial relations–
oriented, is the section on statistical discrimination. Although not done explicitly in the text, you might
want to discuss the link between statistical discrimination and dual labor market (DLM) theory. By tying
statistical discrimination to DLM you can discuss the implications for two groups of workers who, even
though they are perceived to have differential ability at the outset, do not. If one group of workers is
disproportionately directed into the secondary sector and develops the characteristics of secondary
workers, a distribution similar to Figure 18.3 develops independent of the initial distribution.
Additional Applications
Wholesale Used-Car Auctions
Sometimes, buyers can use information about sellers’ characteristics to predict whether a car is a lemon.
Buyers infer that adverse selection is more likely if the seller has an alternative use for a used car. A seller
who is willing to keep the car if the offered price is low is likely to sell only a lemon. In contrast, a seller
who no longer wants the car is much more likely to sell the car whether or not it is a lemon.
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David Genesove (1993) observed this difference in adverse selection at wholesale used–car auctions. Both
used–car dealers, who sell only used cars, and new-car dealers, who sell both new and used cars, attend
these auctions.1 Dealers trade because they receive too many or too few used cars in trade-in, have the
wrong mix of cars for their local retail customers, or are trying to unload lemons.
Retail customers, who have time to inspect and test-drive cars, are more likely to spot a lemon than a
dealer at one of these auctions. At the auctions, potential buyers have only a few minutes to inspect a car
and cannot drive it, so they don’t know if the car is a lemon. After these quick visual inspections, bidding
takes place. The owner then accepts or rejects the highest bid.
New–car and used–car dealers differ substantially in their likelihood of selling a given car. There are three
principal differences between new– and used–car dealers. First, new–car dealers tend to sell to final customers
only recent-vintage used cars that are close substitutes for new cars. Nearly 60 percent of the used cars
sold by new-car dealers are no more than four years old, compared to only 30 percent for used–car dealers.
Second, new-car dealers obtain a higher share of their used cars through trade–ins: 69 percent versus 26
percent. Third, new-car dealers obtain more used cars in trade–ins. Used–car dealers are relatively small: 85
percent obtain fewer than 100 cars in trade–ins and only 2.5 percent obtain 300–600 cars a year. In contrast,
only 7 percent of new–car dealers obtain fewer than 100 cars, 33 percent receive 300–600, and 14 percent
obtain over 600 trade-ins a year.
Because new–car dealers have more trade–ins and sell relatively few older cars, they are more likely to
want to sell their older cars at the wholesale auctions. Indeed, new–car dealers are twice as likely to sell a
six–year–old trade-in at wholesale. Because of this greater tendency to unload all old cars, they are less
likely to engage in adverse selection and keep the higher-quality, old cars.
Thus if the seller is known to be a new-car dealer, we would expect buyers to be willing to pay more for
their older cars. Indeed, new-car dealers receive a premium of 17 percent ($400) over other dealers when
they sell six-year old or older cars. Thus buyers use the identity of the seller as an imperfect signal of
quality.
Similarly, buyers apparently view the number of previous owners as a signal about whether the car is a
lemon. A one-owner car sells for 9 percent ($330) more than multiple-owner cars.
Thus by using information about the number of former owners and the current owner, potential buyers
adjust their estimates of the quality of a car. Although these signals decrease the probability of paying
too much for a lemon, they do not eliminate that possibility.
1. If buyers had more time, or if the auctioneers would certify quality, the asymmetry could be
eliminated. Why doesn’t that happen?
2. Why are extended warranties on used cars sold for an additional fee rather than building the cost into
the price and including them on all sales?
Good Customers Only2
Brad Anderson, chief executive officer of Best Buy Co., embraced a heretical notion for a retailer recently.
He wanted to separate the “angels” among his 1.5 million daily customers from the “devils.”
1 David Genesove, “Adverse Selection in the Wholesale Used Car Market,” Journal of Political Economy, 101(4),
August 1993:644–665.
2Gary McWilliams, “Minding the Store Analyzing Customers, Best Buy Decides Not All Are Welcome,” Wall Street Journal,
November 8, 2004; Page A1.
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Best Buy’s angels are customers who boost profits at the consumer electronics giant by snapping up high–
definition televisions, portable electronics, and newly released DVDs without waiting for markdowns
or rebates.
The devils are its worst customers. They buy products, apply for rebates, return the purchases, and then
buy them back at returned-merchandise discounts. They load up on “loss leaders,” severely discounted
merchandise designed to boost store traffic, then flip the goods at a profit on eBay. They slap down rock–
bottom price quotes from Web sites and demand that Best Buy make good on its lowest-price pledge. Best
Buy estimates that as many as 100 million of its 500 million customer visits each year are undesirable.
Best Buy rolled out its new angel-devil strategy in about 100 of its 670 stores in 2003. It examined sales
records and demographic data and sleuthing through computer databases to identify good and bad
customers. To lure the high spenders, it stocked more merchandise and provided more appealing service.
To deter the undesirables, it cut back on promotions and sales tactics that tend to draw them and culled
them from marketing lists. The new policy has proved to be effective in some of the pilot stores.
1. Analyze the new policy using theory of asymmetric information.
2. Use theory of moral hazard to explain the shopping behavior of the “devils.” Can you think of
alternative strategies to deal with this problem?
Discussion Questions
1. Suppose you go on a fishing vacation to the mountains. Should you ask the local bait shop owner for
the best places to fish?
2. Why is reputation more important to a roofer than to a landscaper?
3. Should the government try to prevent firms from becoming “noisy monopolies”? How would you
word such a law? What would be the advantages and disadvantages?
4. Should the government subsidize the Consumers Union and other nonprofit organizations that
provide comparative brand information? Why or why not?
5. Consulting firms routinely ask potential employees to sign noncompete clauses that prevent them
from quitting and moving to a rival firm within a certain period of time. Why would such an
agreement be so common in this industry?
6. Consumers’ limited information about product prices gives firms market power. Is there a practical
way for the government to reduce or eliminate this problem?
7. Has the Internet increased or decreased consumer information asymmetry? How?
8. Why would a car dealer say “Shop around for the best deal, then come see us last”?
Additional Questions and Problems
1. At many large music stores, potential buyers can listen to a music CD before deciding whether to
purchase it. Why would the seller make such an offer?
2. Suppose you are vacationing on a sunny Caribbean island. You walk to the beach to rent a sailboat
for an hour. A nice gentleman tells you that he has “the best rental prices on the island. You can search
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the entire island and you won’t find a better deal than this.” Under what circumstances should you
believe him?
3. At some urban universities, many students and faculty eat at lunch trucks that are parked along the
streets surrounding the campus. Before going there for lunch one day, you ask two people where you
should eat. Neither individual you ask has ever been there. One says, “Just pick the one with the
shortest line.” The other says, “Pick the one with the longest line.” Which advice should you follow?
4. Evaluate the following statement. “With constantly changing technology, you don’t want to buy a used
computer. On the other hand, if technology were fixed, you wouldn’t want a used computer either.”
5. Under what circumstances would receiving your college degree in two years have a negative effect on
your employability and/or salary?
6. Suppose that only high–quality workers can signal their ability by attending a technical school at
cost c. Wages for highly productive employees are wh; wages for low productivity workers are wl. If
initially a pooling equilibrium occurs, can the firm alter the cost or payoffs to generate a separating
equilibrium? How?
7. Standardized tests are sometimes criticized by parents who claim that their kids spend too much time
studying for them. Under what circumstances is this a valid claim?
8. There are two pricing strategies commonly used by groceries: everyday-low-price and low-and-high
price. If there are two kinds of consumers, one with high search cost and one with low search cost,
what would you expect their shopping patterns will be?
9. Price comparison Web site reduces the cost of a search for the lowest price. What would you expect
their impact on the price distribution. If we observe considerable price variation in Internet prices for
identical goods, can you offer some explanations?
Answers to Additional Questions and Problems
1. Because buyers have often only heard one or two songs on the CD, they may be reluctant to purchase
it for $15. If they like the songs they have heard, but don’t like any others, the per-song cost of those
that the buyer enjoys is high. If they like most or all of the songs, the per–song cost is reduced. Because
of this information asymmetry (the seller knows more about the contents of the CD than the buyer),
risk–averse customers will purchase few CDs. By allowing customers to sample CDs, information is
equalized, and risk–averse buyers can reduce risk at virtually no cost.
2. The claim may be partly true if all sellers are charging the monopoly price or a price that exceeds the
cost of search. (All sellers charge the same; thus, there is no better price on the island.) The claim of
a better price is very unlikely. If there are any search costs for customers, they will be unlikely to
search for this better price. Thus the rental store has an incentive to match the higher price of
neighboring rental shops.
3. There are two possible outcomes. Most of the customers at these restaurants eat at the campus on
a regular basis. Information about restaurant quality travels fast through the student and faculty
community. Thus all restaurants that want to stay in business for any length of time have an incentive
to serve high-quality meals, and you could save time by getting in the shortest line. If, however,
either the restaurants or the cooks at the restaurants turn over frequently, regular patrons will have an
information advantage, and the longest line is the best bet.
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4. With changing technology, used computers are often obsolete and cannot be upgraded to run current
software, making them a poor investment. Only used computers that have current or nearly current
technology will have value that approaches that of new machines. However, there is significant risk
to buying a used computer that is nearly new, since it could be for sale because it is a lemon. With
constant technology, there is no inherent advantage to purchasing a new computer. Thus unless the
seller of a used machine no longer has need for a computer, the machine may also be for sale because
it is a lemon.
5. If employers use years of education as a signal of quality, an individual who has 14 years of
schooling may be viewed as inferior to an individual with 16. The sheepskin effect (completing the
degree) would likely eliminate this disadvantage. A potentially greater disadvantage would be the
signal regarding the quality of the education that an individual received given that he or she was able
to complete in two years a degree that normally takes four years.
6. If the initial solution is a pooling equilibrium, where all workers are paid the average wage, it must be
that the wage premium given to technical school graduates is not sufficient to get them to attend the
school. The firm could either increase the salary offered to graduates or to subsidize the cost of
schooling by offering a hiring bonus such that wh − c > wl. Such a strategy would only pay if the
difference between the value of marginal product for high productivity workers versus low
productivity workers was in excess of the wage premium required to get the high productivity
workers to attend the school.
7. Standardized test scores serve as a signal for both students and schools. Students can signal ability
through high scores. Secondary schools use test scores as a signal of school quality. If schools spend
class time taking practice tests and other preparations for tests such as the SAT and ACT exams, the
amount of time spent on regular curriculum is reduced. Further, if colleges and universities do not regard
standardized test scores as a good signal, they may not weigh them heavily in admissions decisions.
8. With the two kinds of groceries, one should expect the high search cost type consumers to shop in the
everyday-low-price grocery as they will pay for a lower price in average. On the other hand, those with
low search cost will compare prices before they shop and will be more likely to shop in high-and-low
price groceries as they often have deeper sales.
9. Price comparison Web sites are expected to drive price to converge with each other. Reasons behind
price dispersions for identical items may be: (i) difference in service, such as warrantees or return
policies; (ii) some firms may simply charge a higher price, hoping people unaware of the price
comparison Web site or people who do not want to spend time searching for a lower price will shop
at their Web site. This is essentially a “tourist–trap” model.
Answers to Exercises in the Text
1.1 This is moral hazard.
1.2 Because insurance costs do not vary with soil type, buying insurance is unattractive for houses on
good soil and relatively attractive for houses on bad soil. These incentives create a moral hazard
problem: Relatively more homeowners with houses on poor soil buy insurance, so the state insurance
agency will face disproportionately many bad outcomes in the next earthquake.
1.3 Brand names allow consumers to identify a particular company’s product in the future. If a
mushroom company expects to remain in business over time, it would be foolish for it to brand its