ECON200C Notes
Tara Sullivan
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Introduction to Information Economics
Fundamental Contributions to Information Economics
The relevant information available to agents in a market often differs.
Some example of these information asymmetries are:
- •
Akerlof Market for lemons: the seller of used cars often has better
information about the quality of the product than the buyers.
- •
Health Insurance: individuals purchashing a policy have better information
about their own health than the insurance company.
- •
Managerial oversight: a manager cannot observe their workers’ effort,
which effects profits.

The primary question we are trying to address is the effect of information
asymmetries on how institutions work (i.e. given asymmetric information,
are there market inefficiencies? Do markets collapse?). The second
question we address are what policy implementations and informations
can be put into place to correct for the problems associated with
information asymmetries.
Broadly, we will distinguish between two classes of problems:
- 1.
Problems with hidden information: An agent privately observes a piece
of information that matters for his or her payoff, or for another
agent’s payoff. In the used car market, the buyer cares about the
quality of the car. In the insurance example, the information matters
for both the seller’s and the buyer’s payoff. The case of hidden information
results in two types of phenomena:
- (a)
Signaling phenomena: One agent with information attempts to signal
to the other.
- (b)
Adverse selection problem: The informed agent takes an action which
adversely effects the uninformed agent in the relationship. For example,
if the car is a lemon and the seller is successful, then the buyer
is adversely effected by that decision. If the buyer of the insurance
misleads the insurance company, it has a negative effect on the insurance
company.

- 2.
Hidden action: An agent privately takes an action which effects another
agent’s payoff. This is the managerial example; the profit of a task
and the subsequent payoff for the manager depends on the worker’s
effort. The problems that arise with hidden action problems are moral
hazard problems:
- (a)
Moral Hazard: The agent with the hidden action may take an action
that negatively impacts the agent.

Comparison between General Equilibrium and Information Economics
In a general equilibrium, the objective is to achieve some allocation
or outcome by “decentralizing” the realization of this outcome
in society. The question then arises: which allocations can be decentralized?
Theorem 1.1.
[Second Welfare Theorem] Assume:
1. \(\exists\) a benevolent planner^{1}^{1}“Who is benevolent, blah blah blah”
who knows the target allocation. The planner knows which consumer
gets what in order to achieve efficiency.
2. Planner has the power to distribute resources
3. There are market forces (consumers pursue their self interest,
markets work according to a price mechanism^{2}^{2}There is a market and price for each good, agents are price takers.,
etc.) that act as constraints.
Then all efficient allocations can be decentralized.
According to the SWT, if your objective is efficiency, you can decentralize.
Consider information economics’ take on this same problem. Assume:
- 1.
There exists a planner who does not know the target allocation; the
planner does not know how much each agent values a particular good.
- 2.
Agents in society have dispersed information which determines the
target allocation.
- 3.
The market institutions are tools that can be designed to achieve
a certain allocation

According to information economics, efficient allocations generally
cannot be decentralized, and we can achieve only “second-best”
allocations.
Hidden Information
Adverse Selection Problem (MWG 13.B)
A classic example of the “second-best” allocation is asymmetric
information in the labor market.^{3}^{3}MWG 13:B. The model is
characterized by the following:
- •
There is a large number of identical, price taking firms.
- •
The only input for these firms is labor
- •
Each worker has some level of productivity which is represented by
the parameter \(\theta\).
- –
Productivity is bounded so \(\theta\in\left[\underline{\theta},\overline{\theta}\right]\),
\(0\leq\theta\leq\overline{\theta}<+\infty\) and \(\theta\sim F\) with
density \(f>0\).

- •
Each firm’s profit per worker is a result of their productivity minus
wages (\(w\)) paid to the worker, \(\theta-w\)
- –
The reservation wage (\(r\left(\theta\right)\), with \(r^{\prime}>0\)) is the
lowest wage the worker is wiling to accept
- *
\(w\geq r\left(\theta\right)\implies\) the worker chooses to work
- *
\(w<r\left(\theta\right)\implies\) the worker stays home.

Benchmark case - observable productivity
The benchmark case is the competitive equilibrium with \(\theta\) observable;
then this problem is a classical general equilibrium analysis. Under
these conditions, a productivity-specific wage \(w\left(\theta\right)\)
exists for all \(\theta\), and the equilibrium wage is equal to the
productivity of the worker, so that \(w\left(\theta\right)=\theta\)
(inputs earn their marginal product). By the first welfare theorem,
the outcome of this market will be efficient, meaning that:
\begin{align}
w\left(\theta\right)\geq r\left(\theta\right)\implies & \notag \\
w\left(\theta\right)<r\left(\theta\right)\implies & \notag \\
\end{align}
Unobservable productivity
Next consider the (more interesting!) case, which is the competitive
equilibrium when \(\theta\) is not observable for the firms. Under
these conditions, the firm’s offer a single market wage \(w\). Because
the worker chooses to work if and only if \(w\geq r\left(\theta\right)\),
firms can infer something about \(\theta\) from this. Define \(\mu\left(w\right)\)
as the average productivity of the workers who accept employment at
the firm. The firm can compute updated expectation of productivity
based on whether a worker’s reservation wage is higher or lower than
the offered wage so that \(\mathbb{E}\left(\left.\theta\right|r\left(\theta\right)\leq w\right)=\mu\left(w\right)\).
The labor supply for each type of worker is:
\begin{equation}
S\left(w\right)=\mathbb{P}\left(r\left(\theta\right)\leq w\right).\nonumber \\
\end{equation}
Labor demand is:
\begin{equation}
D\left(w\right)=\begin{cases}0&w>\mu\left(w\right)\\
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\end{equation}