Adverse selection, efficiency and the structure of information

Abstract

AbstractThis paper explores how the structure of asymmetric information impacts on economic outcomes in Akerlof’s (Q J Econ 84(3):488–500, 1970) Lemons model applied to the labour market and extended to admit a matching component between worker and firm. We characterize the nature of equilibrium and define measures of adverse selection and efficiency. We then characterize the joint distribution of outcomes—adverse selection, probability of trade, efficiency, profits, and wage—for the class of Gaussian basic games and information, and perform comparative statics with respect to a parsimonious parameterization of the information structure. We use this framework to revisit the classic issue, first addressed by Roy (Oxford Econ Pap 3(2):135-146, 1951), of selection into different sectors. We identify conditions under which an effect reversal—adverse selection at any realisation of public information but, overall, positive selection into the outside sector—can and cannot arise, and note the implications for empirical work. We also explore the divisions of expected total surplus between worker and firm that can be achieved as information varies. We show that, if the distribution of worker types is non-singular, any point in the set of possible surplus divisions can be achieved as a limit of a PBE for some information structure with asymmetric information. Finally, re-interpreting the model in an insurance context, where the matching component becomes consumer risk aversion, we use our framework to highlight sources of advantageous selection.