Asymmetric information

Question 1

How can we calculate probability with frequency if we don’t have history of the event?

Answer 1

The number of times that one particular outcome occurred (n) out of the total number of times an event occurred N

Question 2

What is the expected value and how can we calculate it?

Answer 2

Expected value is the value of each possible outcome times the probability of that outcome summed over all n possible outcomes (weighted sum)

Question 3

What is variance?

Answer 3

Variance measures the spread of the probability distribution or how much variation there is between the actual value and the expected value

Question 4

What is the standard deviation?

Answer 4

The square root of the variance and is a more commonly reported measure of risk. (The higher the standard deviation, the higher the associated risk)

Question 5

When does asymmetric information exist?

Answer 5

When one party to a transaction knows a material fact that the other does not

Question 6

What is a hidden characteristic?

Answer 6

Attribute of a person or thing known to one party but not others

Question 7

What is a hidden action?

Answer 7

An act by one party to a transaction known to one party but not to others

Question 8

What are the two main types of opportunistic behaviour?

Answer 8

• Adverse selection
• Moral hazard

Question 9

What is adverse selection?

Answer 9

Those with weaker information will engage in harmful market behaviour

Question 10

What is an example of adverse selection?

Answer 10

The used-car lemon market

Question 11

If consumers are unable to identify high-quality goods before purchase what will consumers do?

Answer 11

They will pay the same price for all goods (regardless of quality)

Question 12

Why will the market end up with just lemons?

Answer 12

Unravelling under asymmetric information

Question 13

What is unravelling under asymmetric information?

Answer 13

If there is a range of car types and the E(v) is lower than the top range, they leave and this continues until there is only lemons

Question 14

How can information asymmetry be broken?

Answer 14

Signalling and screening

Question 15

How does competition from the demand side effect the price?

Answer 15

It drives up the price

Question 16

What is the equilibrium in the labour market?

Answer 16

Combination of wages for each firm and an acceptance decisions for each worker, such that no firm and no worker can make themselves better off by changing their decision

Question 17

If firms cannot tell worker type, what type of wage to they pay?

Answer 17

The pooling wage rate (expected value of low ability + high ability

Question 18

What does the pooling wage rate mean for high ability workers?

Answer 18

As it is below their expected wage rate, it incentivises finding a credible signal

Question 19

What is a two-stage model here?

Answer 19

Stage 1: Firms announce the wage for high and low-education
Stage 2: each worker chooses education then accepts contracts in any

Question 20

Who is the cost of education higher for?

Answer 20

Low ability workers

Question 21

If education has no effect on productivity, what is the outcome?

Answer 21

DWL

Question 22

How do you find the net surplus from acquiring education for high income workers?

Answer 22

Wage - cost of education

Question 23

What are the key features of separating signalling equilibrium?

Answer 23

• Competing firms make 0 profit

Question 24

What is the wage rate for low ability workers equal to?

Answer 24

Their marginal value

Question 25

What is the wage rate for high ability workers equal to?

Answer 25

High-ability workers receive wages higher than the pooling wage, but they also incur additional cost from education

Question 26

Outline the signalling model?

Answer 26

High ability workers reveal their type by distinguishing themselves from low ability workers through additional effort with no productive value

Question 27

How is the hard contract set?

Answer 27

The hard task and wage are set such that the low-ability type is just indifferent between the two contracts wh-cL=wL = Wh = 2. The high wage is higher than under pooling, face cost from hard task

Question 28

How can we verify that we are in an equilibrium?

Answer 28

By checking that no-one has a profitable deviation

Question 29

How are deviating H-types treated?

Answer 29

As L-types, checking if there is a profitable deviation

Question 30

What is moral hazard?

Answer 30

The lack of incentive to guard against risk when protected from consequences eg. by insurance

Question 31

Examples of hidden action?

Answer 31

• Workers on hourly wages
• Bank managers taking more risk when not liable
• Dangerous driving when insured against accidents

Question 32

What are the different contract types?

Answer 32

1. Wage contracts: P(e)
2. Pure incentive contracts: P(y)
3. Rental contracts: P(y) = y +R

Question 33

Where is the optimal wage?

Answer 33

When the agent is indifferent between accepting and rejecting

Question 34

What does it mean if both the principle and the agent are both risk neutral under a pure incentive contract?

Answer 34

Payoffs = expected individual profit

Question 35

What do pure incentive contracts induce?

Answer 35

Pure incentive contracts induce less effort than first-best and generate lower profit than under observable effort

Question 36

When the agent is risk neutral, what is the outcome under a rental contract?

Answer 36

When the agent is risk netural then the principal can extract the entire surplus with rental contract independent of whether they can observe effort or not

Question 37

When are actions are unobservable, what is the relationship between incentives and work?

Answer 37

Incentives and risk work in opposite directions

Question 38

What is a pooling equilibrium?

Answer 38

A market equilibrium in which both types of goods are traded and
cannot be distinguished by the buyers is a pooling equilibrium.

Question 39

What is a separating equilibrium?

Answer 39

A market equilibrium in which only one of the two types of goods is
traded, or both are traded and can be distinguished by the buyers, is a
separating equilibrium