Suppose that both sellers and buyers can tell which kind of car is which:

(a): SH - DH ; (b): SL - DL ASYMMETRIC INFORMATION: However, as buyers lower their expectations

about the average quality of cars on the market, their perceived demand shifts to DM.

(a) High-quality cars

(b) Low-quality cars

$10,000

PL

$7,500

$5,000

75,00050,000

DL

SH

DH

DM

PH

$10,000

$7,500

$5,000

25,000 50,000

SL

In (b) the perceived demand curve for low-quality cars shifts from DL to DM.

As a result, the quantity of high-quality cars sold falls from 50,000 to 25,000,

and the quantity of low-quality cars sold increases from 50,000 to 75,000.

Eventually, only low quality cars are sold.$10,000

PL

$7,500

$5,000

75,00050,000

SL

DL

(a) High-quality cars

(b) Low-quality cars

SH

DH

DM

PH

$10,000

$7,500

$5,000

25,000 50,000

DLM

DM

DLM

DL

Signaling via Education

B(y)

Value of College Education

$200,000

$100,000

CI (y) = $40,000y

1 32 4 5 60

Optimal Choice of yfor group I

y*

Years of College

B(y)

Value of College

Education$200,000

$100,000

CII (y) = $20,000y

1 32 4 5 60

Optimal Choice of yfor group II

y*

Years of College

(a) Group I

(b) Group II

Without moral hazard: MC = $1.50 per

mile; Driver drives 100

miles, which is the efficient amount.

With moral hazard:MC = $1.00;

Driver drives 140 miles.

Effects of Moral Hazard

Moral hazard alters the ability of markets to allocate resources efficiently. D gives the

demand for automobile driving.

AGENTIndividual employed by a principal to achieve the

principal’s objective.

PRINCIPALIndividual who employs one or

more agents to achieve an objective.

OBJECTIVE

BONUS (dollars/yr)

2000

4000

6000

8000

10,000

10,000 20,000 30,000 40,000 OUTPUTS (units/yr)

Qf = 30,000Qf = 20,000Qf = 10,000

If the manager reports a feasible capacity of 20,000 units per year, equal to the actual capacity, then the bonus will be maximized

(at $6000).

ASYMMETRIC INFORMATION IN LABOR MARKETS: EFFICIENCY WAGE THEORY

17.6

SHIRKING MODELFirm pays its workers the market-clearing wage w*Assumption

Perfectly competitive

markets ALL WORKERS

earn the same wage

Workers have an incentive to slack-off or

shirk.

(Worker): If fired, can get hired somewhere else for the

same wage

Being fired does not impose a cost on workers

Firm then forms an incentive not to

shirk.

Have no incentive to be productive

Assumption Perfectly competitive

markets ALL WORKERS

earn the same wage

SOLUTION: A firm must offer workers a higher wage

Results: Fired workers face a decrease in

wages when hired by another firm at w* (due to shrinking)

If wage difference is large, workers will be induced to be productive

NO SHIRKING = EFFICIENY WAGE

All firms offer We ; [We > W*]EFFICIENCY WAGE (We)

UNEMPLOYMENT!Demand for labor is less than the market-clearing quantityWorkers fired for shirking will face unemployment

before earning We at another firm.

Unemployment can arise in competitive labor

markets when employers cannot accurately monitor workers.

Here, the “no shirking constraint” (NSC) gives the wage necessary to

keep workers from shirking.

The firm hires Le workers (who are offered we), creating L* − Le of

unemployment.

Le L*

W*

We

Wage

Quantity

of labor

DL

SL