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New Institutional Economics: Defining asymmetric information

Exploring another core component of the NIE+ framework — the issue of asymmetric and incomplete information — while also identifying its role in the neoclassical Walrasian model

Continuing with our discussion of the building blocks of NIE+ framework, we will discuss the issue of asymmetric information in this article. As we know, complete and symmetric information is an important assumption in the neoclassical Walrasian model. In other words, 'everyone knows everything' in this general equilibrium model, where commodities are identical, the market is concentrated at a given place and exchange is instantaneous. This assumption is important for allocative efficiency because it allows contracts to be complete and transparent and it ensures costless transactions. In the absence of such an assumption, the maximisation of the objective functions: profit maximisation for firms and utility maximisation for the consumer: would be meaningless and impossible to achieve and lead to market failure. We will discuss this in more detail below.

Theoretical developments

One of the first economists to raise the issue of asymmetric information was George Akerlof, the Nobel Prize winner in Economics in 2002 along with Michael Spence and Joseph Stiglitz. In a 'milestone' paper titled 'Market for Lemons: Quality Uncertainty and Market Mechanism' in 1970, Akerlof argued that if there is asymmetric information between the buyer and the seller, the quality of the good gets affected. Akerlof argued that the benefits of good quality accrued to the entire group of sellers. And, hence, where the quality of the goods is known only to the sellers, there is a lot of incentive for some sellers to sell sub-standard goods and make a fast buck (assuming that the lower quality goods are cheaper to make). In other words, there are positive costs to getting information, which may include costs of ascertaining quality, certification, and measuring attributes of goods and services. Akerlof gave the example of the used car market, where there is a danger that a buyer may be saddled with a 'lemon' or a low-quality car. We will return to the 'lemons' problem below.

Adverse selection & moral hazard

Adverse selection and moral hazard are other examples of market failure in case of asymmetric information. Adverse selection occurs when one party to a transaction lacks information while getting into an agreement or a contract. Moral hazard, on the other hand, occurs when one party lacks information on how the contract or agreement is being implemented. Therefore, adverse selection is about hidden information about characteristics and moral hazard is about hidden information on actions. In other words, adverse selection occurs 'ex-ante' and moral hazard occurs 'ex-post' vis-à-vis the contract and its performance.

Adverse selection

Adverse selection may occur when the seller has greater information than the buyer. It can also occur when the buyer has more information than the seller. The famous example used by Akerlof was the sale of a used car, where the seller, having owned the car, knows the quality of the car better than the buyer. The used car can be of good quality or it can be a 'lemon'( a term Akerlof used for low quality). The buyer assumes that since the seller is willing to sell, the car would be of lesser quality. This is not a definite indication, but on the general principle that owners of lesser-quality goods are more likely to want to get rid of their stuff, the indication is still there. What is worse, a vicious cycle often takes over and the seller has to reduce the price. Since the price is reduced, the owners of good quality cars will withhold their cars from the market. The prices will fall further and so on. Another example concerns financial transactions — for instance when a firm issues debt or equity to outside investors. The investors try to learn as much as they can about the prospects of the enterprise, but it is easy to imagine that insiders to the venture (the entrepreneur in a small venture, or management in a large, publicly-traded firm) know a lot more than outsiders. In these cases and in others, the goods being bought and sold can be of high quality or low or somewhere between. And since the buyer doesn't know, the adverse selection cycle takes over.

The insurance sector offers another ready example for adverse selection and moral hazard. The cost of providing life or health insurance depends on how likely it is that the client will get sick or die. At any premium level, it is precisely the sick who are most anxious to buy insurance. Therefore, in terms of expected payouts on the policy, the insurance company faces an adverse selection of the population as a whole. This can lead to the sort of vicious cycle we saw before. Premium rates must be high, to compensate for the adverse selection problem. This leads the fairly healthy to go without insurance, and the selection of folks signing up for insurance becomes more adverse, raising premiums, worsening the adverse selection and so forth.

Moral hazard

In the examples of asymmetric information discussed above, all concern adverse selection. They involve unobservable characteristics: those that are known in the present time only to the informed party. However asymmetric information may also arise on account of unobservable actions, whereby, at the time of the transaction, one party's future actions will be unobservable to the other. If this asymmetry leads the informed party to behave in a way detrimental to the uninformed party, then there is a moral hazard (Arrow 1971). Going back to the health insurance example, once an individual buys health insurance (even a healthy individual) and he indulges in risky behaviour (like smoking and drinking), and the insurer can't observe this behaviour, moral hazard is said to have occurred.

Another example of moral hazard is when a firm pays an employee but can't observe the output or productivity of the employee. With a fixed wage, the employee has the incentive to shirk. However, other contracts alleviate this issue. For example, as both Stiglitz (1974) and Akerlof (1976) have noted: sharecropping features contracts where sharecroppers receive a share of the harvest, thus giving them an incentive to work hard. However, where such contracts are impossible, wages generally must be higher than market-clearing levels to induce worker productivity.

Way out

Akerlof suggested two ways around the problems of adverse selection and moral hazard: signalling and screening. In signalling, the party with the information credibly discloses private information, while screening occurs when the uninformed party provides a mechanism to incentivise the informed party to credibly disclose private information.

Michael Spence, proposed in 1973 that signalling could fix the problem of asymmetry by allowing people to signal their type. Applying this to the job market, the various ways of signalling could be to obtain a good college degree or signal knowledge of a particular skill through past work experience. This would allow the employer to pay differential wages for varying levels of productivity.

Screening was proposed by Joseph Stiglitz in 1977 when he showed how insurance companies can get around the problem of adverse selection by offering policies that would only attract risk-averse individuals. The companies could thus fragment the market and charge different premiums from the different individuals depending upon the condition (which was reflected by the degree of risk being taken).

Other applications

Stock markets are a good example of a place where asymmetric information plays out. Myers and Majluf (1984) have argued that the stock market has an adverse selection of low-profitability (low-quality) firms. Since some investors cannot differentiate firm quality, the market undervalues high-profitability firms and overvalued low-profitability firms. This incentivises highly profitable firms to finance their projects with debt and low-profitability firms to issue more stock, leading to adverse selection. John and Williams (1985) have argued that high-quality firms overcome this problem by signalling their profitability through dividends, a signal too costly for low-profitability firms.

Another example of asymmetric information is when monopolistic firms use limit prices (prices that are lower than profit-maximising) to deter other firms from entering their market. Milgrom and Roberts (1982) provide a model of this pricing where a monopoly signals its competitive strength to possible new firms through limit pricing or profit-maximising. In the model, weaker firms have an incentive to use limit pricing to mimic stronger firms and deter firm entry.

International relations is another example where asymmetric information is important. A well- known example is the Cuban Missile Crisis analysed using tools of game theory. It may be recalled that the Russian leader Krushchev had agreed to deploy nuclear missiles in Cuba in 1962 in response to the presence of American missiles in Turkey. Additionally, the failure of the Bay of Pigs invasion was playing on Russia's mind. After Kennedy ordered a naval blockade to prevent more missiles from reaching Cuba, the stage was set for a confrontation. Both sides did not have information of the extent to which they would go to stick to their positions: Russia insisting on breaking the blockade and the US countering it by force. The fact that the US was in the middle of an election only made the situation tenser. This was a game-theoretic situation and both sides were intent on displaying their power. However, after thirteen days of intense negotiations, both sides agreed to back-off. Russia agreed to withdraw the missiles headed to Cuba in exchange for the US withdrawing missiles from Turkey. The game of chicken was converted into a situation where both sides cooperated and avoided mutual destruction (in other words, the 'Prisoners' Dilemma' situation where both parties defect and which is a Nash equilibrium, is avoided).

Corporate advertising expenditure provides another example of asymmetric information. Nelson (1974) suggests that advertising may be beneficial for products where purchase is necessary to determine quality. Klein and Leffler (1981) and Milgrom and Roberts (1986) formalise Nelson's ideas in models where firms with high-quality products benefit from advertising, provided they will have repeated interactions with customers. In further extensions, other economists have argued that with identical quality goods, equilibria exist where all firms advertise the same amount.

Most game-theoretic models use asymmetric information between two parties to explore various strategies and explore possible equilibria. The well-known examples of game-theoretic models include 'Prisoners' Dilemma' and the 'Chicken Game' where both players don't know for sure how the other player will react and what information the other player has. It is another matter that in a one-shot 'Prisoners' Dilemma' game, each player has a dominant strategy of ratting each other out, no matter what the other player does. Game theory, in turn, has been used to analyse problems in various areas such as international relations (the Cuban Missile Crisis discussed above), the behaviour of firms in oligopolistic markets (Stackelberg and Cournot models) etc.

Auctions are another area where asymmetric information is important. As we know, an auction is an economic mechanism whose purpose is the allocation of goods and the formation of prices for those goods through the process of bidding. Various auction structures may be either more efficient or more profitable to the seller than others. In all auctions, it is assumed that individuals act strategically and use the private information that they possess. It is worthwhile to note that the Nobel Prize winners this year: Paul Milgrom and Robert Wilson, were awarded the prize for their work on auctions. Robert Wilson came up with the idea of a common value auction, in which information about the nature of what was for sale was shared. The sharing of information can result in higher prices because bidders don't feel the need to underbid to avoid the winners' curse. Paul Milgrom refined this further by suggesting that bidders' private values would make a difference to the amount they would quote. Milgrom argued that in an English auction, bidders use the prices at which other bidders drop out to update their estimates of the product's worth. The auction allows them to revise their estimates back to the mean and protects them from overbidding. But no such learning is possible in a sealed-bid tender where bidders simultaneously submit their offers in a single round, exposing them to the winner's curse. It is here that private values help the bidder. Milgrom and Wilson helped design the 1994 United States broadcast spectrum and the 2012 auction for the Federal Communications Commission, which were successful in allocating spectrum and bringing in a windfall profit for the Commission.

Earlier, William Vickrey also got the Nobel Prize in 1996 for his work on auctions. His 'Revenue Equivalence Theorem', which said that all types of auction yielded the same result for the seller, is well known. Vickery was the first to establish the taxonomy of auctions, namely: the ascending-bid or English auction; the descending-bid or Dutch auction; the first-price, sealed-bid auction; and the second-price, sealed-bid (Vickrey) auction. In the Vickrey auction, as in the first-price, sealed-bid auction, bidders submit sealed envelopes in one round of bid submission. The highest bidder wins the item but at the price offered by the second-highest bidder.

Conclusion

In the past few articles, we have discussed the building blocks of the NIE+ framework, namely transaction costs and property rights, with asymmetric information discussed above. We have seen that the NIE+ framework provides a sound basis for the analysis of a wide variety of public policy issues. We will continue to explore the other building blocks of NIE+ framework in the coming articles.

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