Imperfect_Information_Models - Atlas of Economic Models

Imperfect Information Models

Imperfect information models deal with the problem of asymmetric information, where in the very simple case one side of a potential transaction knows more than the other side, for example the quality of the good a seller is offering, how much a buyer is willing to pay for a particular good or how much effort a worker intends to put into their job. The models presented here are all potential solutions to this problem, using a mechanism (i.e. contract) to give the informed party the incentive to reveal this information to the uninformed party.

Adverse Selection Models

Adverse selection
A hidden information, pre-contractual problem. The informed party knows their 'type', and this is revealed to the uninformed party either indirectly through a screening mechanism or directly via a signal.

The 'Market For Lemons' is an extreme example of adverse selection, where the market fails because there is no incentive for the sellers of low-quality goods to reveal this information to buyers.

The uninformed party offers the informed party a menu of contracts, and from this choice their type is revealed.
The informed party sends the uninformed party a signal to reveal their type.

Moral Hazard Models

Moral Hazard

A hidden action, post-contractual problem. The informed party (Agent) takes some action on the behalf of the uninformed party (Principal), so the uninformed party must design a mechanism such that this action is in their best interest.

Extensions to Principal Agent Model: