Asymmetric Information in Competitive Markets

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1 Chapter 22 Asymmetric Information in Competitive Markets In our treatment of externalities in Chapter 21, we introduced into our model for the first time an economic force (other than government-induced price distortions) that causes a competitive market to allocate scarce resources inefficiently in the absence of some other market or non-market institution. 1 We furthermore illustrated that the problems raised by externalities are problems related to the non-existence of some market, necessitating either the establishment of a new market or the fine-tuning of market forces by some non-market institution. In this chapter, we will see another example of an economic force that can result in the non-existence of certain markets and in an inefficient allocation of scarce resources in existing markets. This economic force arises from certain types of information being distributed asymmetrically across potential market participants and, as we will see, it relates closely to a particular type of externality that is generated in the process. Information is, of course, always different for buyers and sellers with buyers knowing about the tastes and economic circumstances that underlie their demand for a good and sellers knowing the costs of production that underly their supply decisions. One of the great advantages of markets is that, through the formation of market prices, such information is utilized in an efficient manner as the price sends just the right signal to buyers and sellers about how scarce goods should be allocated in the market. Information asymmetries that cause externality problems in markets, however, are different than simply different sets of knowledge about our own individual tastes and costs. They involve hidden information that impacts others adversely because the information can be used to take advantage of the person on the other side of the market. We will then say that information asymmetries occur whenever buyers and sellers have different information regarding the nature of the product (or service) that is being traded or the true costs of providing that product (or service). A common example of this occurs in insurance markets. Suppose, for instance, I approach a health insurance company about my interest in purchasing health insurance. I have inherently more information than the insurance company. In particular, I know more about my own health status and thus the likelihood that I will need health care, 1 This chapter presumes a good understanding of the partial equilibrium model from Chapters 14 and 15 and makes conceptual references to material on externalities from Chapter 21. Section B of the chapter also builds on the non-general equilibrium parts of Chapter 17.

2 808 Chapter 22. Asymmetric Information in Competitive Markets than the insurance company, and I know more about how my lifestyle might change if I know that I am insured. This is information the insurance company would very much like to have in order to ascertain the likely cost of providing insurance to me. The worse my health is and the more likely I am to engage in risky behavior if I am insured, the more costly it is likely to be for the insurance company to provide health insurance to me. And I have every incentive to hide bad health or a tendency toward risky behavior as I approach the insurance company to get a good deal on health insurance. If the insurance company cannot distinguish between people who are hiding information about their health and those who simply want insurance but have nothing to hide, it may end up finding it impossible to provide insurance packages that healthy individuals would be willing to buy. Thus, the problem of asymmetric information and the associated problem of those with hidden information adversely selecting into insurance markets, can lead to missing markets. Similar problems arise in other markets. In the used car market, for instance, the owner of a used car may have significantly more information about the quality of the car than do potential buyers. In labor markets, workers know more about their real qualifications than employers may be able to ascertain. In mortgage markets, potential homeowners may know more about their real ability to make mortgage payments in the future than do the banks that lend money. In pharmaceutical markets, drug companies may know much more about the real effectiveness of particular drugs than do patients or even doctors. And in financial markets, corporate officers know more about the true financial health of a corporation than does the average shareholder. Each of these cases shares some of the characteristics of insurance markets in that one side of the market has inherently more information that is relevant for the market transaction than does the other side, which then may make the other side hesitate about entering a transaction. And in each case there may exist other market mechanisms, civil society institutions or government policies that can alleviate the problems markets face in dealing with such information asymmetries. This chapter is organized somewhat differently from other chapters in that Section A is written without requiring that you have covered the topic of risk in Chapter 17. You can gain an appreciation for the problems markets encounter under asymmetric information without understanding fully how we model risk, and Section A attempts to provide such an understanding. However, since information asymmetries represent particular problems for insurance markets that deal with risk (as described in Chapter 17), Section B of the chapter builds on the framework for insurance under risk and we introduced in Chapter 17. If you have covered only the intuitive first part of Chapter 17, you can still read the subsections (of Section B below) that focus on a graphical exposition of the impact of asymmetric information in insurance markets. For this reason, the mathematical exposition in Section B is confined to separate subsections. 22A Asymmetric Information and Efficiency We will discover in this Section that the presence of hidden information on one side of the market can generate inefficiencies by resulting in externality problems. In some cases, this will lead to the non-existence of markets that, if information were more generally available, would make everyone better off. In other cases, it will lead to market distortions in which we can see in principle how more information will lead to greater efficiency. We will develop these ideas initially through a treatment of one hypothetical insurance market before illustrating the deadweight losses in a set of more familiar graphs. Then, in the final two sections of Part A of this chapter, we will return to real world examples that exhibit the phenomena introduced earlier in more abstract settings.

3 22A. Asymmetric Information and Efficiency A.1 Grade Insurance Markets Let s begin with a somewhat silly example. Suppose I approached your professor the day before the beginning of the semester and told him I wanted to sell grade insurance in your class. Here is how it would work: If a student wants to insure that he gets at least a grade x in the class, he can purchase insurance that guarantees him grade x as a minimum grade for a price p x. Higher grade guarantees will carry with it a higher price. At the end of the semester, the professor and I will sit down and look at the legitimate grade distribution and particularly at the grades earned by those who bought insurance from me. If an earned grade falls below x for which a student bought insurance at the beginning of the semester, I have to pay the professor to overcome his scruples and raise the grade, with the size of the payment depending on how much the grade needs to be raised in order to get to the grade for which the student had bought insurance. If, on the other hand, a student who bought insurance for grade x actually earned a grade at or above x, no grade adjustment is necessary and no cost is incurred by my grade insurance company I just get to keep what the student paid me without dishing out anything to the professor. To make this example more concrete, let s suppose that the grade insurance business is perfectly competitive (which implies that each grade insurance company will end up making zero economic profit in equilibrium), and let s suppose that grades in your course are curved (prior to me paying off the instructor to raise some grades) around a C, with 10% of all students earning an A, 25% earning a B, 30% earning a C, 25% earning a D and 10% earning an F. 2 Finally, let s suppose that your professor s scruples are such that it costs a minimum of c for him to raise your grade by one letter grade (and 2c to raise it by two letter grades, 3c to raise it three letter grades, etc.). 22A.1.1 A-Insurance and The Adverse Selection Problem To focus on one particular problem that the grade insurance market faces, suppose first that only A-insurance can be offered and that student behavior will be exactly the same whether or not a student has insurance. Students who buy insurance at the beginning of the semester thus study and work just as hard in the class as they would have in the absence of having insurance. Students themselves have a pretty good idea whether they are likely to do well or poorly in the class, but as an outsider coming in, I don t know anything about any individual student and only know the distribution of grades that will emerge at the end. If everyone were forced to buy the A-insurance, it would not be difficult to determine the equilibrium insurance premium p A if we know that everyone in the grade insurance business makes zero profit in equilibrium. We would know that I would have to pay 4c for everyone in the 10% of the class that earns an F, 3c for everyone in the 25% of the class that earns a D, 2c for everyone in the 30% of the class that earns a C and c for everyone in the 25% of the class that earns a B. The insurance premium would then be p A = 0.1(4c) (3c) + 0.3(2c) c = 2c. (22.1) The price of A-insurance would thus simply be determined by how much it takes to pay off your professor to raise a grade by 1 level. If that price is $100, the premium would be equal to $200 per student. 2 Note to my students at Duke: I understand that we have grade inflation at Duke so please don t write me s telling me that this is not a Duke curve.

4 810 Chapter 22. Asymmetric Information in Competitive Markets Exercise 22A.1 What would be the equilibrium insurance premium if, in a system that forced all students to buy insurance, the only insurance policy offered were one that guarantees a B? What if the only policy that were offered was one that guaranteed a C? Suppose, however, that we do not force everyone to buy a particular policy but simply left it up to individual students to determine whether or not to buy insurance. If it were reasonable to expect the set of students who choose to buy insurance to be a random sample of the class, the exact same logic that we used above would result in exactly the same premium. 3 It seems likely, however, that those students choosing to buy insurance will not represent a random sample, with students who are expecting an A in the class anyhow uninterested in purchasing insurance. Thus, if I charged the insurance premium in equation (22.1), I would lose money. Now suppose that all students are willing to pay as much as 2c to raise their grade by one level and 0.5c for any additional increase in the grade by another level. Put differently, an F student is willing to pay 2c to raise his grade to a D, 2.5c to raise his grade to a C, 3c to raise his grade to a B and 3.5c to raise his grade to an A. Exercise 22A.2 In an efficient allocation of grade insurance (when only A-insurance is offered), who would have A-insurance? (Hint: Compare the total cost of raising each student type s grade to the total benefit that this would yield for each student type.) Exercise 22A.3 If all types of insurance policies were available i.e. A-insurance, B-insurance, etc. who would have what type of insurance under efficiency? (Hint: Compare the marginal cost of raising each student type s grade by each level to the marginal benefit of doing so.) This would imply that 90% of the class would be willing to buy the A insurance if it were offered at a premium of 2c. But my insurance company would now incur higher costs. If the class has 100 students in it, I would incur a cost of c for the 25 B students, a cost of 2c for the 30 C students, a cost of 3c for the 25 D students and a cost of 4c for the 10 D students for an overall cost of 200c or an average cost of 2.22c for each of the 90 students that buy the insurance. In order for me to make zero profit, I therefore have to now charge a premium of 2.22c for the A-insurance. But at that price, the B-students would no longer be willing to pay for the A-insurance because the price is above what they are willing to pay for a 1 letter grade increase in their grade. This means that I would have to charge a premium of approximately 2.69c for the same insurance policy in order to break even if only C, D and F students bought my insurance. Exercise 22A.4 Verify that my break-even insurance premium for A-insurance would have to be approximately 2.69c if only the 65 C, D and F students bought the insurance. But now the C students are no longer willing to pay for the insurance since they are willing to pay only 2.5c to raise their grade by two levels 2c for the first level and 0.5c for the second. Thus, only D and F students are willing to pay 2.69c for my A-insurance. But if they are the only ones buying, you can verify that my premium has to go up to approximately 3.29c sufficient to get only F students to be interested in the A insurance, which would then necessitate a premium of 4c which not even F students are willing to pay. Thus, if students are allowed to choose whether or not to buy A-insurance, I will not be able to sell any insurance in equilibrium if the students know what kind of students they are and I do not. This is an example of a more general problem known as the adverse selection problem that can arise in markets with asymmetric (or hidden) information. 3 It is true that this would involve some risk for the insurance company since a random sample will sometimes contain relatively more good students and other times relative bad students, but if the insurance company sells many of these types of contracts in different classrooms, that risk would disappear.

5 22A. Asymmetric Information and Efficiency 811 The adverse selection problem arises in our example because each student has more information than my insurance company about how much of a cost I will incur if I sell him grade insurance. As a result, students will adversely select into buying insurance from me with high cost students more likely to demand insurance than low cost students. It would be efficient (as you should have concluded in exercise 22A.2) for B and C students to hold A insurance in our example, but neither does. 4 As in the case of the externalities in Chapter 21, the competitive equilibrium is inefficient. Even if students cannot perfectly predict what grade they will earn in the absence of insurance, they will have more information than I do about the probability that they will earn a good grade. Thus, even if students that end up earning an A in the absence of insurance are willing to buy insurance at the beginning of the term, they will still be willing on average to pay less than those who end up with a worse grade. Because of the adverse selection problem, students who line up to buy insurance from me therefore impose a negative externality in the market by raising the average cost of insurance (and thus the premium I have to charge). Their decision to enter the market adversely impacts the other students. It is this negative externality that arises from asymmetric information, and it is because of the presence of this externality that a market equilibrium does not exist in our example. Exercise 22A.5 Would I be able to sell A insurance if students were always willing to pay 2c for every increase in their letter grade? Would the resulting equilibrium be efficient? 22A.1.2 Information, Adverse Selection and Statistical Discrimination We have seen above how the asymmetry of information in the A-insurance market can lead to a non-existence of the insurance market due to the negative externality generated through adverse selection. To focus a little further on how asymmetric information causes this, we can consider how the equilibrium (or lack thereof) will change if I am able to obtain the information that we have so far assumed only students possess. Suppose first that I can observe student transcripts at the beginning of the semester and, from them, I can perfectly infer what grade each student will make at the end of the term in the absence of insurance. I could then offer each student a menu of insurance policies and price them with that information in mind. For a B student, for instance, I could offer the A-insurance at a price of c which the student would be more than willing to pay (with me making zero profit). For C, D and F students, I could similarly price A-insurance at 2c, 3c and 4c respectively, with C and D students willing to pay the price but F students unwilling (since such insurance is worth only 3.5c to them). We have thus restored the market for A-insurance by eliminating the informational asymmetry. We have furthermore done so in an efficient way, with insurance sold only to students whose willingness to pay is above the cost of the insurance product. The real world, of course, is never that certain, and neither students nor I can perfectly predict what grade they will end up earning at the end of the term in the absence of insurance. Suppose, then, that I observe from transcripts what grades a student has made on average and am therefore able to classify students into A students, B students, C students and D students. Suppose I also know by looking at the past performance of students in your course that A students earn an A 75% of the time and a B 25% of the time, and all other students earn a grade one level above 4 It is efficient for B and C students to hold A insurance (when only A insurance is an option) because the cost of raising their grades is c and 2c respectively while their benefit from getting an A is 2c and 2.5c respectively. The benefit is equal to the cost for C students and it is therefore efficient for them to have or not have insurance. But F students benefit by 3.5c and cost 4c.

6 812 Chapter 22. Asymmetric Information in Competitive Markets their usual grade 25% of the time, their usual grade 50% of the time and a grade below their usual grade 25% of the time. Assuming that students have no more information than I do, I could then again offer the different insurance policies to each type of students at a premium that will result in an expected zero profit for me. For instance, since I know that I will incur a cost of c with 25% probability for an A student, I can price an A-insurance policy for an A student at 0.25c. Similarly, since I know a B student who purchases an A-insurance will cost me nothing with 25% probability, c with 50% probability and 2c with 25% probability, I can price an A-insurance for a B student at c. You can verify on your own that the equilibrium price for an A-insurance would again be 2c for a C student and 3c for a D student. Exercise 22A.6 What would be the equilibrium price p F A for an F student if that student will earn an F with 75% probability and a D with 25% probability? Notice that nothing has fundamentally changed if the grade outcome is uncertain so long as it is equally uncertain from the student s perspective as it is from mine. As long as the student has no more information than I do, whether that information involves uncertainty or not, no adverse selection problem will arise and an equilibrium price will emerge for A-insurance but will differ depending on what type of student is purchasing the insurance. When I have perfect information about each student and can perfectly predict the type of grade he will earn in the absence of insurance, I will discriminate based on the individual characteristics of the student. In the case where both I and the students are somewhat uncertain about what the semester will hold, however, I end up discriminating based on the statistical evidence I have regarding the probabilities that a particular student will earn particular grades. Such price discrimination that is based on the underlying characteristics of the group to which an individual belongs is called statistical discrimination. 22A.1.3 The Moral Hazard Problem Throughout our discussion of the problems in our silly A-insurance market we have made the heroic assumption that students will study just as hard and diligently if they have grade insurance as if they did not. But would they? Or would the knowledge of the guarantee of a certain grade offered by my insurance company cause some students to blow off the material, stop coming to class, stop studying perhaps even skip exams? If you have stuck with this course all the way through Chapter 22, chances are you are the kind of student that gets at least some satisfaction from actually learning rather than just getting a grade on a transcript. Perhaps you are even that rare student who would work just as hard if there were no exams and no grades given. But students will vary in terms of how much value they place on the grade relative to the actual learning in a course which implies that the degree to which students will change behavior under my grade insurance will differ across students. The problem of individuals changing behavior in this way after entering a contract is known as the moral hazard problem and it makes executing the contract more expensive for the other party to the contract. If all students react the same to being insured, then I can at least predict how much more they will cost me than they would if they continued to behave as if they were not insured. If, for instance, a random selection of half the class buys A-insurance from me, we calculated earlier that a premium of 2c would make my expected profit zero in the absence of moral hazard. But, if each of the students who bought insurance then changes behavior sufficiently to end up with one letter grade below where he would have ended up otherwise, I would have to charge a premium of 3c to have an expected profit of zero. The anticipation of moral hazard behavior by those I insure

7 22A. Asymmetric Information and Efficiency 813 therefore implies I must charge more than I otherwise would, and it arises in insurance markets whenever individuals engage in riskier behavior when insured. If students differ in their change in behavior once they have insurance, however, we have a bigger problem than simply higher insurance premiums assuming students know themselves better than I know them. Once again, I would possess less information about the student than the student himself possesses, and this will reinforce the adverse selection problem that we discussed in the absence of moral hazard. Even if I could identify the A, B, C, D and F students from their transcripts and knew precisely what grade each will earn in the absence of insurance, I would now have to worry about the fact that some of each type of student will exhibit greater moral hazard once they are insured than others. The B student that knows he can earn a B in the course and knows that he will work just as hard if he is insured will not, for instance, be willing to pay as much for A-insurance as the B student who knows he can enjoy the beach a whole lot more if he has A-insurance. Thus, students will adversely select into my insurance pool based on the level of moral hazard they will exhibit once insured. As long as they know this information and I do not, we can get the same kind of unraveling of the insurance market we saw in our initial example of adverse selection. Adverse selection, then, causes problems for insurance companies because of the adverse externality that high cost customers impose on low cost customers as they drive up the price of insurance and may cause insurance markets to no longer function in equilibrium. Moral hazard by itself, on the other hand, is a problem that insurance companies can, in our example, deal with through pricing of premiums. However, if moral hazard creates informational asymmetries because insurance companies cannot identify how different individuals will engage in different levels of risky behavior once insured, this creates another adverse selection problem that can once again undermine the existence of markets. Much has been written by economists about the optimal ways in which insurance companies (and others facing moral hazard problems on the other side of the market) can arrange contracts so as to minimize moral hazard behavior. Although we will not develop this formally in this chapter, you can think of some possible conditions my insurance company might place on those who buy grade insurance. For instance, I might require as part of the contract that your professor certifies at the end of the term that students who will benefit from owning grade insurance have in fact attended class, handed in assignments and taken exams. (Issues like this are often covered in courses on the economics of contracting.) For now we can simply note that, to the extent to which insurance companies can find ways of minimizing moral hazard through contractural arrangements as they sell insurance, they limit the adverse selection problem that accompanies the existence of moral hazard. 22A.1.4 Less Extreme Equilibria with Adverse Selection So far, we have demonstrated that the adverse selection problem may cause certain markets not to exist. This is an extreme manifestation of the problem of adverse selection, and not all markets that are subject to adverse selection will cease to exist entirely. Suppose, for instance, that your professor will not permit me to sell A-insurance but only agrees to let me sell B-insurance i.e. insurance that guarantees a student will earn at least a B in the course. To make the example as simple as possible, let s assume that there is no moral hazard problem, that students know exactly what grade they will earn, that I have no information about any individual student and that it is prohibitively costly for me to gather any useful information on individual students. We know right away, of course, that no A or B student would then be interested in buying insurance from me. In a class of 100 students, only the 65 C, D and F students are therefore

8 814 Chapter 22. Asymmetric Information in Competitive Markets potential customers. If they all end up buying the insurance from me, I know that I will incur a cost of c for the 30 C students, 2c for the 25 D students and 3c for the 10 F students. My average cost per customer is then 110c/65 or approximately 1.69c. Since students are willing to pay 2c for a one level increase in their grade and 0.5c for each additional level increase, we know that C, D and F students would be willing to pay 2c, 2.5c and 3c for B-insurance and thus are all willing to pay my break-even premium of 1.69c. In this case, the adverse selection problem is therefore not sufficiently large to eliminate the equilibrium in the B-insurance market. Exercise 22A.7 Conditional on only B insurance being allowed, is this equilibrium efficient? Now suppose that student demand for grade insurance was slightly different: suppose a student is willing to pay 1.5c for a one level increase in his grade and c for each additional increase. This implies that C students would only be willing to pay 1.5c for B-insurance, less than the premium of 1.69c I have to charge to break even when all C, D and F students buy insurance. If I therefore end up providing B-insurance to only the 35 D and F students, you can verify that I would have to charge a break-even premium of approximately 2.29c. Since this is less than the value D and F students place on B-insurance, the equilibrium would involve 35 B-insurance policies sold to just those students. Now, the externality of adverse selection causes fewer policies to be sold, but an equilibrium still exists. Exercise 22A.8 Conditional on only B insurance being allowed, is this equilibrium efficient? The example can, of course, get a lot more complex if the professor allows me to sell all forms of insurance i.e. A, B, C, D insurance. In end-of-chapter exercise 22.1, we will investigate this more closely under the assumption that individuals are uncertain about exactly the grade they will get and are willing to pay 1.5c to get their typical grade but only 0.5c more for each grade above their usual. In this case, it is inefficient for anyone to buy insurance other than insurance to guarantee his usual grade. This is because the cost of insuring your usual grade is c while the benefit is 1.5c but raising your grade each level above the usual is valued at only 0.5c but costs c. As we will demonstrate in the exercise, adverse selection will result in inefficiency once again. 22A.1.5 Signals and Screens to Uncover Information At this point, we have shown how asymmetric information can cause problems in our grade insurance market. It should be clear from our example, however, that good or low cost students have an incentive to find ways of credibly revealing information to my insurance company so that I can give them a better deal. Similarly, my insurance company has an incentive to invest in ways of uncovering information by getting access to transcripts, interviewing students, etc. Put differently, students have an incentive to signal information to me, and I have an incentive to screen the applicant pool. You can explore in end-of-chapter exercises 22.2 through 22.4 how such signals and screens can be efficiency enhancing and how they can be wasteful under different assumptions about the grade insurance market. We will furthermore revisit the issue in the next section after exploring a more graphical model that frames the ideas we have explored thus far in a different (and more realistic) setting. 22A.2 Revealing Information through Signals and Screens Let s now move away from the artificial grade insurance market and consider the case for insurance more generally. While our treatment in this section can be applied to all types of insurance, we ll

9 22A. Asymmetric Information and Efficiency 815 frame our discussion in terms of car insurance. Suppose that there are two types of potential consumers: high cost consumers that are likely to get into accidents, and low cost consumers that drive safely and are less likely to call upon insurance companies to pay for damages. We can then think of car insurance for type 1 consumers carrying an expected marginal cost of MC 1 and car insurance for type 2 consumers carrying an expected marginal cost of MC 2, with MC 1 > MC 2. To make the example as simple as possible, let s suppose further that demand curves are equal to marginal willingness to pay curves and that the aggregate demand curve D 1 for type 1 consumers is the same as the aggregate demand curve D 2 for type 2 consumers. Panel (a) of Graph 22.1 then illustrates what the car insurance market would be like if there were only type 1 consumers, and panel (b) illustrates what it would be like if there were only type 2 consumers. In each case, it is straightforward to predict how the competitive market would allocate resources (assuming there are no substantial recurring fixed costs to running insurance companies): In panel (a), the equilibrium price p 1 would cause consumers of type 1 to purchase x 1, the efficient quantity that maximizes social surplus. In panel (b), the equilibrium price p 2 would similarly cause type 2 consumers to buy x 2 insurance policies once again allocating resources efficiently. And if a competitive insurance industry can tell type 1 consumers apart from type 2 consumers, this is exactly the outcome that will emerge with all insurance policies priced at the marginal cost relevant for the type of consumer who is purchasing insurance. Graph 22.1: Adverse Selection in Car Insurance Market Panel (c) of Graph 22.1 then merges panels (a) and (b) into a single picture. If insurance companies can tell safe drivers apart from unsafe drivers, type 1 consumers will get consumer surplus equal to area (a) while consumers of type 2 will get consumer surplus equal to area (a+b+c+d+e+f). Since insurance firms are making zero profit, the overall social surplus would then be equal to (2a + b + c + d + e + f). 22A.2.1 Deadweight Loss from Asymmetric Information Now suppose that firms cannot distinguish between type 1 and type 2 drivers and thus cannot price car insurance based on the expected marginal cost of each consumer that walks through the door. Rather, the only information that firms have is that half of all drivers are of type 1 and half

10 816 Chapter 22. Asymmetric Information in Competitive Markets are of type 2. Each insurance company then gets a random selection of drivers to insure and thus knows that half their customers are high cost and half are low cost. Under perfect competition that drives profits for insurance companies to zero, this implies that the single price charged for car insurance will lie halfway between MC 1 and MC 2 indicated by p in panel (c) of Graph Exercise 22A.9 Suppose the current market price for car insurance were less than p. What would happen under perfect competition with free entry and exit? What if instead the market price for car insurance were greater than p? Is is easy to see immediately that high cost consumers will benefit from the information asymmetry we have introduced their price for car insurance drops from p 1 under full information to p. Consumers of type 2 will analogously be hurt by the informational asymmetry seeing their price increase from p 2 to p. The fact that some consumers are better off and some are worse off does not, however, itself raise an efficiency problem. Rather, the efficiency problem emerges from the fact that overall consumer surplus falls as a result of the informational asymmetry. To be more precise, we can see in panel (c) of Graph 22.1 that consumer surplus for type 1 consumers increases to (a + b + c) while consumer surplus for type 2 consumers falls to (a + b + c) giving us an overall surplus of (2a + 2b + 2c). Note that area (b) is equal in size to area (d) which means we can re-write this overall surplus as (2a+b+2c+d). Note further that the triangle (c) is equal in size to triangle (f) which means we can further re-write the overall surplus as (2a + b + c + d + f). Comparing this to the full information surplus of (2a + b + c + d + e + f), we have lost area (e) which is therefore the size of the deadweight loss from introducing asymmetric information that keeps firms from pricing insurance policies differently for consumers of type 1 and 2. 5 To provide some intuition as to where this deadweight loss comes from, we can note two further geometric facts in Graph 22.1: Area (g) is equal to half of area (e), and area (f) is equal to area (g) (and thus also equal to half of area (e).) Thus, the deadweight loss can equivalently be stated as area (f + g). Panel (a) of the graph places area (g) into the graph for just consumers of type 1 where we originally said that consumers would buy x 1 insurance policies when they are priced at marginal cost. All the way up to x 1, the marginal benefit (as indicated by the demand curve) exceeds the marginal cost and it is therefore efficient to provide policies up to x 1. For policies after x 1, however, the marginal cost of providing additional insurance policies exceeds the marginal benefit making it inefficient to provide policies beyond x 1. When x policies are bought by type 1 consumers, the deadweight loss from this over-consumption of insurance is then area (g). The reverse holds in panel (b) for low cost consumers whose marginal benefit exceeds marginal cost until x 2 but who reduce their consumption to x under the uniform price p. Thus, consumers of type 2 are now under-consuming insurance with the deadweight loss (f) emerging directly from this under-consumption. Exercise 22A.10 True or False: The greater the difference between MC 1 and MC 2, the greater the deadweight loss from the introduction of asymmetric information. Exercise 22A.11 Suppose that type 1 consumers valued car insurance more highly implying D 1 lies above D 2. Can you illustrate a case where the introduction of asymmetric information causes type 2 consumers to no longer purchase any car insurance? What price would type 1 consumers then pay? 5 It may seem that our analysis relies too heavily on symmetries that emerge from the assumption that type 1 and 2 consumers do not differ in overall number or demand. End-of-chapter exercise 22.5 illustrates that the analysis, while notationally more complex, is similar when these assumptions are relaxed.

11 22A. Asymmetric Information and Efficiency 817 Notice that the adverse selection problem in our car insurance market is very much like the problem we first encountered in the grade insurance market of the last section: consumers that cost less to insure safer drivers or better students are driven out of the insurance market by rising premiums due to the adverse selection of consumers who cost more to insure. The result in Graph 22.1 is less extreme in the sense that not all low cost consumers are driven out of the market and not all high cost consumers come into the market. But the basic economic forces are the same. 22A.2.2 Screening Consumers The asymmetric information equilibrium in Graph 22.1 (which is replicated in panel (a) of Graph 22.2) is called a pooling equilibrium because all consumer types end up in the same insurance pool with the same insurance contract while the full information equilibrium in which the different types are charged based on their marginal cost is called a separating equilibrium (because the types end up in separate insurance contracts). When asymmetric information leads to pooling of different types, however, it would be to the advantage of an insurance company to find a way of screening out high cost customers and providing insurance to only low cost types. Given that there is a demand for screening services that identify who the safe drivers are, we might then imagine that a screening industry will form a competitive industry that screens consumers and sells information to insurance companies. Suppose first that this screening industry becomes very good at gathering information on consumers so good, in fact, that the marginal cost of gathering information on any particular driver is virtually zero. In that case, competition in the screening industry will drive the price of screening services (paid by insurance companies) to zero. Put differently, if the screening industry becomes very good at gathering information on drivers, information will be revealed to insurance companies at roughly zero cost. This then leads us back to the full information separating equilibrium in which high cost drivers are charged a price p 1 and low cost drivers are charged p 2. The emergence of a screening industry that screens consumers at low cost therefore restores the efficient equilibrium and recovers the dead weight loss from the pooling equilibrium. Exercise 22A.12 How much do type 1 consumers lose? How much do type 2 consumers gain? What is the net effect on overall consumer surplus? But now suppose that information is not all that easy to gather. In particular, suppose it costs q per driver to gather sufficient information to allow the screening firms to tell type 1 drivers apart from type 2 drivers. If insurance companies buy this information for all drivers that apply for policies, insurance companies will have to pass this screening cost onto consumers in order to maintain zero profits. But they can t pass it onto type 1 consumers because if the price for high cost insurance policies rose above p 1, a new insurance company could emerge and simply sell insurance at p 1. So, in order for insurance companies to make zero profit, they will have to price the policies of low cost customers above MC 2 to pay for the screening price charged by the screening firms for both type 1 and type 2 consumers. Thus, the new separating equilibrium will have p 1 = MC 1 and p 2 = MC 2 + β where β > q and sufficient to cover all the screening costs for both types of consumers. Suppose, then, that the screening cost q per driver is such that β = (p MC 2 ) is required in order for insurance companies to make zero profit in the separating equilibrium where they charge p 1 = MC 1 to type 1 consumers. This implies that p 2 = p i.e. the insurance premiums for low cost drivers remain unchanged from the pooling equilibrium because of the screening cost, But the premiums for high cost drivers rise to MC 1 because insurance companies can now tell who the

12 818 Chapter 22. Asymmetric Information in Competitive Markets Graph 22.2: Insurance Companies Screening Drivers unsafe drivers are and thus will no longer insure them below marginal cost. In panel (a) of Graph 22.2, consumer surplus for type 1 drivers then falls by (b + c) (from (a + b + c) to just (a)) while consumer surplus for type 2 drivers remains unchanged. Overall consumer surplus therefore falls by (b + c) raising the deadweight loss that already existed in the initial pooling equilibrium. But wait it gets worse! The cost of screening customers is paid to screening firms who make zero profit and thus is not a benefit to anyone. In panel (a) of Graph 22.2, this cost is equal to area (d+ e), which means that the increase in deadweight loss from moving to the separating equilibrium is (b + c + d + e). Exercise 22A.13 Why is the screening cost equal to area (d + e)? Exercise 22A.14 * Why do firms in this case pay a screening cost that does not allow them to lower any premiums? (Hint: Think about whether given that everyone else pays for the screening costs and discovers who are the safe and unsafe drivers an individual firm can do better by not discovering which of its potential customers are type 1 and which are type 2.) Thus, as screening costs rise, the move from a pooling equilibrium with asymmetric information to a separating equilibrium (where the asymmetric information is eliminated through screening) becomes inefficient. This is because gathering information is itself costly to society, and someone will have to bear that cost. While the pooling equilibrium without screening gives rise to deadweight losses, these deadweight losses can then be reduced through screening only if the cost of gathering information is relatively low. Panel (b) of Graph 22.2 illustrates a less extreme case where the separating equilibrium price p 2 lies below the pooling equilibrium price p because screening costs are lower than previously assumed. Type 1 consumers still lose (b + c) in consumer surplus as their premium rises to MC 1, but type 2 consumers now gain (h + i) in consumer surplus. Thus, overall consumer surplus changes by (h + i b c). Screening costs are furthermore equal to (j + k) implying an overall change in social surplus of (h + i b c j k) as we move to the screening equilibrium. Note that as screening costs fall toward zero, (j + k) approaches zero while (h + i) approaches (d + e + f). Since

13 22A. Asymmetric Information and Efficiency 819 (d + e + f) is unambiguously greater than (b + c), overall surplus therefore increases for sufficiently low screening costs. Exercise 22A.15 Could there be a screening-induced separating equilibrium in which p 2 is higher than p? Exercise 22A.16 Would your analysis be any different if the insurance companies did the screening themselves rather than hiring firms in a separate industry to do it for them? 22A.2.3 Consumer Signals Suppose next that insurance companies find it too costly to screen consumers and we are therefore in our pooling equilibrium where p is charged to all drivers. As we have already shown, this implies that low cost drivers are paying too much and high cost drivers are paying too little. It is therefore in the interest of low cost drivers to find a way to signal insurance companies that they are a safe bet and, if they succeed in signaling their type, it becomes in the interest of high cost types to falsely signal that they, too, are safe drivers. Whether a separating equilibrium can emerge in the insurance market through consumer signals then depends on the cost of signaling your true type as well as the cost of falsely signaling that you are a different type than you actually are. Consider first the extreme case where it is costless for type 2 drivers to signal that they are safe but it is very costly for type 1 drivers to falsely signal that they too are safe drivers. Because it is easy for type 2 drivers to reveal information that can then not easily be obscured by type 1 drivers, a full information separating equilibrium with insurance premiums p 1 = MC 1 and p 2 = MC 2 will emerge and the deadweight loss from pooling will be eliminated through consumer signaling. If, on the other hand, it is equally costless for type 1 drivers to pretend to be type 2 drivers, this cannot happen and we simply remain in the pooling equilibrium where no useful information is conveyed to the insurance companies. Exercise 22A.17 True or False: When it is costless to tell the truth and very costly to lie, consumer signaling will unambiguously eliminate the inefficiency from adverse selection. Now suppose that things get a little murkier in that it costs δ for type 2 consumers to signal that they are safe drivers and it costs γ for type 1 consumers to pretend to be safe drivers. If the industry is currently pooling all drivers into a single insurance contract with price p, type 2 drivers would be able to reduce their premiums to MC 2 if they can credibly signal that they are safe drivers, thus each getting a benefit of (p MC 2 ). So long as δ < (p MC 2 ), it therefore makes sense for a type 2 consumer who is currently paying p to absorb the cost of signaling his type and get his premium lowered to MC 2. Suppose, then, that the type 2 consumers successfully signal their type and induce a separating equilibrium where the industry charges MC 2 to type 2 consumers and MC 1 to type 1 consumers. The only way this can truly be an equilibrium is if it is too costly for the type 1 consumers to falsely signal that they, too, are safe drivers and a type 1 consumer in a separating equilibrium would be willing to pay as much as (MC 1 MC 2 ) the difference between the low and high insurance premiums to pretend to be a safe type! Thus, we can get a separating equilibrium if δ < (p MC 2 ) and γ > (MC 2 MC 1 ) i.e. if the signaling cost plus the low cost insurance premium is less than the pooling insurance premium for safe drivers, and if the cost of lying is greater than the difference between the low and high cost insurance rates. Is this outcome necessarily efficient? Just as in the case of screening, the answer again depends on how high δ the cost of revealing information is.

14 820 Chapter 22. Asymmetric Information in Competitive Markets Exercise 22A.18 Suppose δ = (p MC 2 ) and γ > (MC 1 MC 2 ). What is the increase in dead weight loss in going from the initial pooling equilibrium to the separating equilibrium? Exercise 22A.19 True or False: If δ and γ are such that a separating equilibrium emerges from consumer signaling, the question of whether the resulting resolution of asymmetric information enhances efficiency rests only on the size of δ, not the size of γ. But there is another possibility: Suppose δ < (p MC 2 ) and γ < (MC 1 MC 2 ); i.e. suppose the cost of truthfully signaling that you are a safe driver is less than the amount that safe drivers are overpaying in our initial pooling equilibrium and the cost of lying is less than the difference between the marginal costs imposed on insurance companies by the two types. It is then possible to get a pooling equilibrium with signaling where both types send signals that they are safe drivers but because both types send these signals, no actual information is conveyed to the insurance companies who therefore continue to price all policies at p. Given that everyone is sending an I am safe signal, not sending such a signal might be interpreted as you being unsafe and thus everyone will send them because everyone else is sending them. 6 This is of course unambiguously inefficient consumers are sending costly signals without revealing any actual information and thus without changing anything in the insurance industry. Exercise 22A.20 * Is it possible under these conditions for there to also be a pooling equilibrium in which no one sends any signals? (Hint: What would insurance companies have to believe in such an equilibrium if they did see someone holding up the I am safe sign?) Exercise 22A.21 * Suppose (p MC 2 ) < δ = γ < (MC 1 MC 2 ). Will there be a separating equilibrium? (Hint: The answer is no.) Exercise 22A.22 Why is it possible for a signaling equilibrium to result in a pooling equilibrium in which no information is revealed but it is not possible to have such a pooling equilibrium emerge when firms screen? 22A.2.4 Information Costs and Deadweight Losses under Asymmetric Information Our example of car insurance has illustrated two fundamental points: First, as already shown in our grade insurance examples, the presence of asymmetric information may cause pooling equilibria in which behavior is based on average characteristics rather than individual characteristics. This will lead to the emergence of deadweight losses as some will over-consume while others will underconsume (relative to the efficient level) or, if the problem is sufficiently severe, entire markets will cease to exist. Second, it may be possible for information asymmetries to be remedied through the revelation of information either because the informed side of the market signals or because the uninformed side of the market screens. But this only leads to greater efficiency if the cost of transmitting information is relatively low and if the information that is exchanged is actually informative (and thus leads to a separating equilibrium). We will explore these ideas further in end-of-chapter exercises, including some where we will investigate the possible outcomes of signals and screens within our grade insurance markets. But now we turn to a discussion of some of the most prevalent real world situations in which asymmetric information plays an important role. As you will see, many of these have nothing to do with insurance even though they can be understood with the tools we have developed within the insurance context. 6 It is not clear what insurance companies should believe in this case about someone who deviates from the behavior of everyone else and does not send an I am safe signal, but it is certainly possible that insurance companies would believe such individuals to be of type 1. We will discuss how economists might think about such out-of-equilibrium beliefs in Section B of Chapter 24.

15 22A. Asymmetric Information and Efficiency A.3 Real World Adverse Selection Problems In our development of the basic demand and supply model of markets earlier in the book, we distinguished between three different types of markets: output markets in which consumers demand goods supplied by producers, labor markets in which producers demand labor supplied by workers, and financial markets in which producers demand capital from investors (or savers). Asymmetric information can appear in any of these markets, and we will therefore treat each of these separately below. As before, we will point to three types of institutions that can then ameliorate the externality problem created by adverse selection. New markets like the screening firms in our car insurance example might appear and facilitate the exchange of hidden information; non-market civil society institutions might play a similar role, or government policy might be crafted to address the problem. And in many instances a combination of these approaches is utilized in the real world. 22A.3.1 Adverse Selection in Output Markets We have already discussed extensively the problems of adverse selection in one particular output market where the output is insurance. In some insurance markets, there is much that insurance companies can observe about individuals (thus giving rise to a relatively small adverse selection problem), while in other insurance markets much remains hidden information. In the case of life insurance, for instance, the chances of a consumer using the insurance can be predicted reasonably well so long as the insurance company knows a few basics such as the consumer s age, gender, health condition and whether or not she smokes. (For life insurance policies with high benefits, they might also require a basic health exam.) While some consumers might behave more recklessly if their life is insured (thus giving rise to a moral hazard problem that can strengthen adverse selection), most consumers probably will not change behavior significantly just because their heirs will receive a payment if they die. 7 Life insurance companies can therefore use relatively costless screens to categorize consumers into different risk types and then price life insurance policies accordingly. As a result, we rarely hear of calls for government intervention in life insurance markets, with insurance providers employing an army of actuaries who predict the probability of premature death for different types of consumers. Exercise 22A.23 Another factor that lessens the adverse selection problem in life insurance markets is that the bulk of demand for life insurance comes from people who are young to middle aged and not from the elderly. How does this matter? In the case of unemployment insurance, on the other hand, markets may face considerably more difficulty in overcoming the adverse selection problem. As someone approaches an insurance company to inquire about unemployment insurance policies, it is difficult for the insurance company to tell whether the consumer is asking for this insurance because she knows that she is about to get laid off. Age or health exams do not provide a useful screen (as they do in the case of life insurance) the hidden knowledge is much more difficult to unearth. Consumers themselves may also not find easy ways to signal their type. It may therefore be the case that signaling and screening are too costly for widespread unemployment insurance markets to form without some nonmarket institution to spur such a market. Before governments became involved in insuring everyone, certain civil society institutions, for instance, utilized local knowledge of individual reputations 7 An exception to this involves individuals contemplating suicide, and suicide is therefore typically excluded as a cause of death that would trigger an insurance payment.

16 822 Chapter 22. Asymmetric Information in Competitive Markets to provide insurance within small communities where individual reputations were relatively wellknown. In most developed countries, such institutions disappeared when governments instituted mandatory unemployment insurance for everyone using compulsory unemployment insurance taxes to fund the system. Tenured professors with lifetime job security (who would not voluntarily purchase unemployment insurance) as well as workers in industries whose fortunes fluctuate greatly with the business cycle then all pay into the system in hopes that overall consumer surplus is increased even as some are paying for a service they do not require all because the adverse selection problem may be sufficiently severe for private markets and civil society institutions to offer too little insurance. Exercise 22A.24 In our car insurance example, asymmetric information caused the market to create a pooling equilibrium in which some over-consumed and others under-consumed. Why might this not be the case in the unemployment insurance market where those with high demand are much more likely to be those with high probability of being laid off? (Hint: Can you imagine an unraveling of the market for reasons similar to what we explored in the grade insurance case?) Exercise 22A.25 Is mandatory participation in government unemployment insurance efficient or do you think it might just be more efficient than market provision? In yet other insurance markets, a combination of approaches has emerged. For instance, in the US, health insurance for the non-elderly is provided largely by private insurance companies. However, the government covers some segments of the population (the elderly and the poor) directly through Medicare and Medicaid, and it subsidizes employers to provide health insurance to their employees. Large employers then enjoy an additional advantage in that they have a large pool of workers that is less risky to insure than individuals. And an ethical civil society standard (often also codified into laws) in the medical profession requires doctors in emergency rooms to treat uninsured patients thus effectively providing at least some form of implicit insurance to the formally uninsured. Debates over whether this is the right balance of markets, civil society and government in the health insurance market continue in the US, while in other countries governments have approached health insurance much as the US has approached unemployment insurance. My goal is not to offer an answer as to what the best approach to a fairly complicated set of issues is but merely to point out that adverse selection (and moral hazard) has something to do with the policy debates surrounding this issue. You can learn more about this in public finance and health economics courses and in end-of-chapter exercises 22.7, 22.8 and Exercise 22A.26 What is the adverse selection problem in health insurance markets? What is the moral hazard problem for such markets? Exercise 22A.27 It is often proposed that health insurance companies not be allowed to discriminate based on pre-existing health conditions. Does this ameliorate or aggravate the adverse selection problem? Can you see why such proposals are often accompanied by proposals that everyone be required to carry health insurance? Insurance markets, however, are not the only output markets that might suffer from adverse selection problems. The used car market, for instance, is plagued by adverse selection but this time the hidden information resides with the supplier rather than the consumer. You may have heard that, when you buy a new car, its value drops by several thousand dollars the moment you drive it off the lot. Why? Because if you were to try to sell this car to someone else the week after you bought it, potential buyers would (rightfully) wonder whether you have discovered something about the car that is not observable to them and whether you might not be adversely selecting

17 22A. Asymmetric Information and Efficiency 823 (as a seller) into the used car market. Consumers in the used car market can then employ various screens to try to get to the potentially hidden information screens such as taking the used car to a trusted mechanic who can give an independent third party certification of quality. Or used car dealerships might offer warranties that signal to consumers the quality of the used car. Some brands of cars are known to have fewer problems and so brand names can signal quality. Brand names, warranties and third party certifications therefore all represent ways that hidden information can be unearthed and at least partially overcome the adverse selection problem. Exercise 22A.28 Consider used car dealerships in small towns. How might reputation play a role similar to brand names in addressing the asymmetric information problem? In a world with increasingly complex products, the issue of product quality that is potentially hidden from consumers of course extends far beyond the used car market. The quality of much of what I see in stores from computers to televisions to kitchen appliances to over-the-counter medications is difficult for me to evaluate. Again, warranties can signal quality, as can the brand names that have good reputations. Third party certification groups (such as the magazine Consumer Reports) have emerged. They routinely test products and sell the information to me in a separate market (through, for instance, the Consumer Reports magazine or web-site), and consumer advocacy groups outside the market provide similar services. The American Heart Association puts its seal of approval on certain foods. And industry groups have often established industry standards, sometimes requiring third party certification to insure quality. Even my underwear has stickers that try to signal quality informing me that Inspector 10 had done his job. While all these signals are costly and thus use some of society s resources, they nevertheless can be (and often are) socially beneficial if they are not too costly and lead to more widespread information that can overcome adverse selection externalities in markets. At the same time, some producers might be able, at least in the short run, to signal that their products are of higher quality than they actually are, expending wasteful effort to hide their true type in order to end up in a pooling equilibrium with high quality producers. Thus, just as in the example of car insurance, signals may in some instances represent a socially wasteful use of resources aimed at deceiving rather than informing, or they may be too costly even when they result in a resolution of the information asymmetry. Exercise 22A.29 What is Consumer Reports analogous to in our discussion of car insurance? Finally, as in insurance markets, the government often steps in as well. Cigarette packages contain dire warnings required by law, and my barber has a sign on his mirror telling me that he is licensed to cut hair. We will see in later chapters that there may be other, less benign reasons why my barber had to get a license to operate and we therefore might be careful in interpreting such government involvement as solely serving the purpose of reducing adverse selection. Our goal here, however, is not to sort out which of the various signals and screens aimed at adverse selection problems are good and which are bad which truly raise social surplus and which are socially wasteful. Rather, I simply want to persuade you that a variety of market, civil society and government supported signals and screens in fact operate at least in part because markets by themselves might not perform optimally in the presence of adverse selection. 22A.3.2 Adverse Selection in Labor and Capital Markets There is only so much that an employer can ascertain about a potential employee before hiring him. The adverse selection problem in labor markets therefore occurs when workers have hidden

18 824 Chapter 22. Asymmetric Information in Competitive Markets information about their own productivity. Education, work experience and letters of reference offer ways for us to signal information to our employers, but workers with identical resumes may still be quite different on the job. Additional information might be signaled less formally in job interviews aimed at screening applicants. Depending on the cost of the signal relative to the benefit, such efforts may once again be socially productive in the sense that they convey true information or socially wasteful if they signal false information or are simply too costly. We are often led to believe, for instance, that more education is always better. This may be true if the only reason for someone to get more education is to truly increase productivity on the job (and if the marginal cost of additional education is greater than the marginal benefit for the student). But in some instances, education may simply serve as a signal masking the underlying productivity of a worker. If the cost of getting the signal of having attained a certain level of education is sufficiently low, then low-productivity workers might get an education simply to end up in a pooling equilibrium with truly high-productivity workers. While this may make the unproductive worker better off, it dilutes the information of the signal and does not serve to convey the information that employers seek. 8 If you take a course on the economics of education or in labor economics, you will probably find yourself debating the issue of whether your college increases your real productivity or simply serves as a screening institutions that signals something about you that was already there when you started as a freshman. (This is explored in more detail in exercise ) Exercise 22A.30 Which of the following possibilities makes it more likely that widespread college attendance is efficient: (1) Colleges primarily provide skills that raise marginal product, or (2) colleges primarily certify who has high marginal product. The same issues arise in financial markets. Banks and mortgage companies have less information than those who apply for loans. Applicants therefore seek ways of signaling their creditworthiness and banks seek ways of screening applicants. In the past when individuals moved less often and resided more within small communities, one s informal reputation was an important signal if everyone knows Joe is a liar and a cheat, there is not much point to lending him money. In today s world, such informal mechanisms are less effective, but other institutions have taken their place. Credit companies keep detailed records on anyone who has ever had a credit card or a loan or a bank account. We are often told to be sure to build a credit history precisely because this signals something about us that may come in handy when the time comes to apply for a mortgage. Thus, as informal reputations became less effective, new markets formed markets that gather and sell information about our creditworthiness. In many ways, our credit report has become our reputation in credit markets. We face similar information problems when we try to decide where to invest our money. Companies try to get us to buy their stocks, and banks try to sell us various types of savings instruments with different risks and returns. Often, the places we consider investing have much more information about their true value than we do, and we therefore have to expend effort, or hire someone to expend effort in our place, to gather information that might be hidden. Again, there exist many different financial advising firms that now specialize in gathering such information and selling it to us for a price (or a commission), and non-profit ( civil society ) institutions provide information on firms (often on web sites accessible to potential investors). In addition, the government has 8 Note that the adverse selection problem is less severe if it is easy for firms to fire workers who prove less productive than they initially appeared, but many laws and regulations as well as union protections for workers often make firing workers costly for firms.

19 22A. Asymmetric Information and Efficiency 825 created its own oversight mechanism, requiring financial disclosure statements by publicly traded companies and offering their seal of approval in terms of deposit insurance to banks. 22A.4 Racial and Gender Discrimination Many societies, including the US, continue to struggle with overcoming social problems arising from the legacy of racial and gender discrimination. Such discrimination has deep historical roots, dating back to some of the darker periods in history when prejudice was endemic and often explicitly supported by government policy. Despite legislation that now outlaws such discrimination, studies continue to suggest instances when applicants for employment (in labor markets) or credit (in financial markets) are offered different wages or interest rates despite identical observable qualifications, with less favorable deals offered to women and minorities. We will see in this section that such discrimination may persist in markets even when old prejudices have died out if markets are characterized by asymmetric information of the type discussed throughout this chapter. 22A.4.1 Statistical Discrimination and Gender Consider first a case where gender discrimination characterizes market transactions in the life insurance market. We have already discussed how life insurance companies calculate the expected probability of premature death for individuals. Smokers, for instance, are required to pay higher life insurance premiums than non-smokers because, on average, smokers die earlier than non-smokers. At the same time, many of us know of people who smoked all their life and ended up living to a ripe old age. Smoking appears to be more damaging to some than to others, with some individuals being fortunate to have genes that protect them from the adverse consequences of smoking. Even if I know that my family tends to be able to smoke like chimneys and still survive to an old age, insurance companies will discriminate against me in their pricing policies if they know that I smoke. Because they lack information on my individual probability of being affected by smoking, they discriminate based on the statistical evidence on smokers as a group they engage in statistical discrimination because of the informational asymmetry that keeps them from knowing fully my individual characteristics. The same reason that causes statistical discrimination against smokers in life insurance markets then also causes statistical discrimination against men in these markets. Women on average live longer than men and so my wife, despite the fact that her family seems more predisposed to cancer and heart disease than mine, ends up getting a better deal on life insurance than I do. The same is true of young people in car insurance markets you might be a much better driver than I am, but because I am older and on average people my age get into fewer accidents, you end up having to pay a higher car insurance premium than I do. Statistical discrimination discrimination based on the average statistics of the demographic groups to which individuals belong is therefore economically rational in insurance markets that are characterized by asymmetric information. Exercise 22A.31 What are we implicitly assuming about the costs of screening applicants in these markets? While we may not see a big moral issue arising from such statistical discrimination in insurance markets, we might be considerably more disturbed when the same type of discrimination emerges in other markets. On average, for instance, women are more likely to exit the labor force for some period in order to raise children. This is not at all true for some women, and an increasing number of men are also taking larger responsibility for child rearing. Employers, however, have a difficult time identifying which women and men are individually more likely to exit the labor force for child

20 826 Chapter 22. Asymmetric Information in Competitive Markets rearing, but it is easy for them to identify whether employees or potential employees are men or women. As a result of this asymmetric information, employers may therefore use the underlying statistics of average behavior by men and women to infer the likelihood that a particular employee will be with the company for a long period. As a result, they may statistically discriminate against female employees, offering them lower wages or less job training in anticipation of the greater likelihood that they will leave the company. Notice that, from a purely economic perspective, this is no different than the insurance company statistically discriminating against me when my wife and I apply for life insurance because the company does not have full information, it uses the available statistical evidence to infer information that is true on average but may be false for any given individual. And, just as in the case of life insurance, the discrimination that results in equilibrium may have nothing to do with companies inherently preferring one gender over another. Exercise 22A.32 True or False: Statistical Discrimination leads to equilibria that have both separating and pooling features. 22A.4.2 Gender Discrimination based on Prejudice versus Statistical Discrimination When we observe incidences of gender discrimination, it is therefore difficult to know whether the discrimination arises from inherent prejudices or from economic considerations due to asymmetric information. Discrimination based on prejudice is defined as discrimination that arises from tastes that inherently prefer one group over another while statistical discrimination arises from asymmetric information. Life insurance companies that charge lower premiums to women do not do so because they like women more than men they do so because women on average live longer than men. Similarly, employers who discriminate against women in labor markets may be motivated solely by economic considerations rooted in asymmetric information. Let me be clear: I am not arguing that such discrimination may not be due to more pernicious causes related to good-old-boys on corporate boards feeling uncomfortable about allowing women more economic opportunities. I am simply pointing out that the same logic that causes life insurance companies to discriminate in favor of women (and against smokers) may also lie behind some of the discrimination against women we might observe in labor markets. Nor am I saying that only taste discrimination based on prejudice should disturb us but understanding the root causes of discrimination may help us better formulate solutions that eliminate all forms of gender discrimination. Exercise 22A.33 Suppose public schools invested more resources into gender sensitivity training in hopes of lessening gender discrimination in the future. Would you recommend this if you knew that gender discrimination was purely a form of statistical discrimination? Markets, for instance, tend to punish employers for discriminating based on prejudice. Suppose that companies A and B in a competitive market are identical in every way except for the fact that company A is governed by a corporate board that is prejudiced against working with women while company B is not. This implies that company B has a larger pool of talent to draw from and will be able to gain a competitive advantage over company A by employing qualified women. Both companies may operate in equilibrium, but the prejudiced company will earn lower dollar profits because part of its profit comes in the form of prejudiced corporate leaders getting utility from excluding women. Shareholders should prefer to invest in company B that makes more dollar profits, which implies that the stock of company B will have higher market value than the stock

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