Economics of information:

Decision making  in  the presence  of  uncertainty  encounters problem due  to peculiarities of information.  We  have seen in the preceding unit that inefficiencies creep  into  the  insurance  contracts  on account  of  adverse selection. As we  saw, just  because one party held  better information on the risk involved  (the insured knew her health status better than  the  insurer), the

market outcome was a distorted one.  In  another instance (in case  if driver's insurance) lack of perfect monitoring on the part of insurer resulted in insured choosing to act differently after buying the  insurance, which  led to  influence the utility of the insurer. Information asymmetries of these types are pervasive in many other economic  relations. It is not difficult  for you to find,

• customers know more about their tastes than the firm;
• firms know more about their costs than the government; and
• employees  know more about  their capabilities than the employer.

The net  result of all these instances is that  individuals who hold such private information are expected to manipulate it to their advantage. Thus, holding the information acts as if  they  have monopoly power  over  its price.  In  order  to take that into consideration, we need to know some of the important concepts information and analytical  tools available for drawing inferences. The  following discussion  is introductory in nature.  It  attempts  to  bring  in some  basic concepts of  information  economies and  provides a preliminary analytical framework while seeking solution to problems.  In  the process you will be exposed to designing of basic contract between two parties taking into account the constraints imposed by  the prevailing institutional settings. For advanced level discussion, which we will not cover presently, you will resort to the insights of game theory with asymmetric information for solving many of such problems.

Remember that studies  of  behaviour under asymmetric information involve strategic interaction among agents. A worker, for example, might have better idea on her  capabilities than the employer. However, by  carefilly observing her behaviour, the employer might be  able to  infer the worker's capabilities. Consequently, he might design incentive structure to get best work efforts. On the other hand, good workers might want to be known as efficient or otherwise, according  to the payment package being offered.

Another aspect of solution to present discussion, you may take note of, is the designing of incentives. Recognisation  of  private information being in the possession of some agents, necessitates additional cost to  be  incurred for arriving at optimal solution among the parties. In  the following we  start with Principal-Agent framework to  highlight  the problems encountered  due  to  asymmetric  information  and extend the discussion to cover applications such  as  hidden  action,  hidden  information and eficiency wage model.