INFORMATION ECONOMICS
(Mirrlees , William Vickrey, Akerloff, Spence, Stiglitz, Hurwitz.Myerson, Maskin & Alvin Roath)
In the 1950’s George Stigler explained that price differences of products are due to expensiveness of search and information. Since then, information economics has grown steadly.
Stiglitz observes that information is costly and further it is asymmetric. Because of asymmetics of information between buyers and sellers, markets fail and misallocate resources. As such Stiglitz argues for government intervention.
Three main themes arise in situation in which asymmetric information exists in a contractual relationship, that is to say, in which one participant knows something that another does not. They are: Moral Hazard, Adverse, Selection and Signaling. In the Contractual relationship in which the participants could be individuals, institutions or firm, let us refer to the participants as Principal and Agent. The Principal is responsible for designing and proposing the Contract, while the Agent, who is contracted to carryout some task decides, if he is interested, in signing or not.
In the context of Information asymmetry, Moral Hazard problems have to do with the behaviour of the Agent during the contractual relationship. The Agent’s behaviour is not observable by the Principal, it is not verifiable (for a Court of Law). The first formal papers on Moral Hazard are those of Mirrlees. A classic example here is Fire insurance where the insure (agent) may or may not take adequate care while storing the flammable materials. It is possible for the Fire insurance company to send inspectors to see that the insurer takes proper care. But perfect monitoring is not possible.
Agents frequently do not act in the best interests of the Principals. Against the interest of the employer (Principal), the workers may not be working very hard, preferring to idle away time by doing work at a slow pace. Similarly, in a company, the shareholders are owners and the managers are the agents. The managers (agents) may pursue goals other than that profit maximization. The resulting inefficiency due to such conflicting goals is termed ‘X’ inefficiency.
Such problems can be tackled by proper monitoring of the performance of the agents by the principals. Further, there must be incentives for the agents to behave in the principals interests. Thus, managers’ salaries could be linked to firms’ profitability.
William Vickery won the Noble Prize jointly with Mirrless in 1996. Vickry deals with the problems of design mechanism in economics, especially with the writing of Contracts among parties who will come to have private information. Vickery suggested a design mechanism known as ‘Second-Price Sealed Bid Auction’., termed as ‘Vickery ‘s Auction’
In this type of auction system suggested by Prof. Vickrey the person who is willing to pay the highest price gets the chance to buy the good and he pays the social opportunity cost, which is the second highest bid. Hence, this auction design is socially efficient. The bidders are induced to reveal their true valuations of the good.
The ‘Adverse Selection’ problem is present, when before signing the Contract, the party that establishes the conditions of the Contract (the Principal) has less information than the Agent on some important characteristics affecting the value of the Contract.
Early important contributions to ‘Adverse Selection’ problems came from Akerloff. Akerloff gives the illustration of the used cars, which are in good condition (Peaches) and in bad Condition (Lemons). In a secondhand car market, there is a tendency of ‘Bad Used cars’ driving out the good cars.
If the good and bad cars are sold at the same price, owners are more likely to offer a bad car for sale than a good one. Potential buyers of used cards suspect that the cars on the market are bad. Accordingly, they reduce the price they are willing to pay. At the reduced prices, the sellers will have no incentive to sell good cars. In such a vicious circle, the market for used cars may even collapse.
While information is imperfect and asymmetric, persons can take steps to provide others with the signals or proxies for the relevant variable. Michael Spence in a path-breaking article points out that education of candidates for a job serves as a signal to the employer. Employer has no prior information about the ability of candidates. They initially believe that persons having education, say degree are more able than others., who are believed to be less able.
On this basis, the employers offer higher wages or salary to more able candidates and low wages to less able persons. The candidates in turn fulfill the employers expectations. It is assumed that the cost of education (acquiring a degree) is higher for less able persons as they take more time to get it than the less able persons. In such a context, only the more able persons find it worthwhile to acquire the needed degree as a signal about their ability. And For the Employer taking the degree as a signal of their ability offers higher wages to all those candidates having a degree.
In the Moral hazard example, we referred to Employer and Employee relationship. The Employer (Principal)designs the contract to induce high effort on the part of the Agent. The agents expected pay-off for high effort must be at least as great as his pay-0ff from low effort. This kind of inequality is called the incentive compatibility constraint.
In the car example above it was assumed that the buyer had no information about the quality of the car. However, the buyer (the Principal) while designing the contract can motivate the seller (the agent) to reveal his private information about the quality of the car. The Contract specifies a guarantee for the car’. The seller would accept the contract only if the car is a good quality.
The 2007 Nobel Prize is awarded to Hurwitz, Myerson and Maskin for their Contributions to mechanism design theory. An important feature of collective decision making is that it takes into account individual preferences. But the individual preferences are not publicly observable. How the information can be elicited, and the extent to which the information revealation problem constrains the ways in which collective decisions can respond to individual preferences, is known as mechanical design problem. As Engineers design bridges and machines, analogously economists design exchange mechanisms such as telephone exchanges and auction markets. According to Hurwitz, the theory attempts to achieve incentive compatibility among the agents. Meyerson Revealation Principle induces people to reveal their private information truthfully. Maskins Implementation theory clarifies when mechanisms can be devised that only produce Nash equilibrium that is incentive efficient.
The work of these Nobel Economists of 2007 is closely related to that of non-cooperative game theories of Hasranyi, Nash and Selten and to the theories of Vickrey and Mirrlees referred earlier in this chapter.
As design theories form a constituent of game theory, books and chapters on game theory may be consulted for more details.
The Nobel Prize 2012 is awarded jointly to Professors Shapely & Alvin Roath. While Shapely used Game Theory to analyze different matching methods in the 1950’s & 960’s, Roath applied matching methods for allocations and the practice of market design. Those interested in knowing more about Roath’s contributions they may read his book (Co-edited with J.Kagel), Handbook of Experimental Economics, Princeton University press, 1995.
Design theories, Game theories and Experimental Economics are interrelated.
Chapter 16