The Economics of Information

Here are my notes and thoughts on Economics of Information.

Asymmetric information means that one party has superior information to another party. In many markets, buyers and sellers have different information, which can lead to market inefficiencies. Asymmetry in information is due to either hidden characteristics or hidden actions. In cases with hidden characteristics, agents can use their private information to decide whether to participate in a transaction or a market, causing adverse selection.

In cases with hidden actions, an agent can take an action that adversely affects another agent, causing moral hazard. There are both private and government solutions to reduce the effects of adverse selection and moral hazard. 

Upon some reflection, you will find that life presents many interactions in which one party to a transaction has different information from the other-information that the other party cares about. We refer to such discrepancies in knowledge between buyers and sellers as asymmetric information. We also say that the party with information that the other party to the transaction does not possess has private information. 

We can distinguish two kinds of asymmetric information. First, hidden characteristics, in which one party in a transaction observes some characteristics of the good or service that the other doesn’t observe. Second, hidden action, in which one party in a transaction takes actions that are relevant for, but not observed by, the other party. 

If information gaps are large enough, it is possible in theory for a market to completely shut down, even if everyone could benefit from trade. 

Both types of asymmetric information can have profound impacts on markets. 

Adverse selection occurs when one agent in a transaction knows about a hidden characteristic of a good and decides whether to participate in the transaction on the basis of this private information. 

A warranty is an example of signaling, in which an individual with private information takes action, sends a signal, to convince someone without the information that his services or his products are high quality. The idea is that warranties are particularly expensive for low quality products, because these tend to break down more often. But low quality producers shy away from offering warranties because it will end up too expensive for them to make good on the warranties when their products die. So the fact that any particular item has a warranty means the item is high quality and you do not need to buy an extended warranty. 

Used cars sell for about 20 to 40 percent less than new cars of the same year and model, particularly when they are not certified by dealers. 

Hidden actions occur when an agent does not observe relevant actions taken by another agent with whom he is transacting. When hidden actions on the part of one agent influence another agent’s payoffs, we say that there is a moral hazard. 

People tend to take more risks if they don’t have to bear the costs of their behavior. 

The party with the hidden action is the agent. The uninformed party, who can design a contract before the agent chooses his actions, is the principal. 

Under moral hazard, the uninformed party can sometimes design a contract to incentivize the party with private information. Economists refer to such relationships as a principal-agent relationship. 

Efficiency wages refer to wages above the lowest pay workers will accept. Employers use the higher wage to increase productivity. 

Higher-paid workers might wish to work harder because a higher-paying job is more valuable to them, and the risk of not succeeding in this job-and thus having to quit or be fired-becomes potentially more costly.

Higher wages might encourage workers to stay longer with the company, reducing turnover and thus the costs the employers will incur for recruiting and training new employees. Moreover, the longer employment relationships that result with low turnover might increase worker productivity through experience effects. Higher wages might thus increase profits via both channels.

Higher pay might motivate the worker psychologically. For example, workers who perceive generosity from their employers might perceive this as a gift and reciprocate by working harder at their jobs-a phenomenon sometimes dubbed gift exchange in the economics literature. 

The government can improve equity, but often at the cost of reduced efficiency. 

Economists understand that some amount of unemployment has always existed in market economies and is largely unavoidable. It takes time for workers to find jobs suited to their skills and interests.

Moral hazard is present in the problem facing unemployed workers because an individual’s efforts to find a job and decision whether to take an offer are private information. 

The presence of moral hazard in the behavior of unemployed workers introduces an unavoidable trade-off in the design of unemployment benefits, greater equity and insurance for unemployed workers and their families come at the cost of reducing worker effort to find new jobs. 

Problems of asymmetric information are relevant not only when governments engage in redistribution, as in the unemployment case, but also when they try to enforce law and order. 

Government rules are everywhere. All states enforce laws, uphold property rights, and prevent crimes. If they did not, society would have to suffer through the detrimental actions of quite a few bad apples. 

Many real world markets are characterized by asymmetric information because of important information disparities between buyers and sellers. 

One type of asymmetric information is driven by hidden characteristics, meaning that certain characteristics are hidden from either buyers or sellers. Hidden characteristics lead to adverse selection when agents can use their private information to decide whether to participate in a transaction.

Another type of asymmetric information is due to hidden actions, which arise when one party to a transaction can take actions not observed by the other party that affect everyone’s payoffs. Hidden actions lead to moral hazard problems.

Although the market has developed means to deal with information asymmetries-such as warranties, deductibles, certification, and efficiency wages-in many situations, these may be insufficient, and government intervention may be useful to limit the inefficiencies that asymmetric information creates.