Introduction

This chapter studies the interaction in markets when there is one-sided private or hidden information. The emphasis is on markets rather than simple bilateral relationships.

The key assumption is that the party that sets the terms of the contract lacks information about some relevant characteristics of its customers. This is often paraphrased as the uninformed-party-moves-first assumption.

The main conclusions are:

1. Hidden information gives rise to an efficiency problem. But the nature of the distortion differs radically according as one has adverse or positive selection.

2. There is an incentive to introduce self-selection or screening of customers in the form of rationing or nonlinear pricing.

3. In a screening equilibrium, the least preferred customers exert a negative externality upon the more preferred types. This externality is completely dissipative.

4. A screening equilibrium is generally improvable.

5. However, a screening equilibrium does not always exist.

The chapter closes with an in-depth analysis of bilateral trading between a monopolist and his customer, which generalizes the theory of second-degree price discrimination from Chapter 1 to a continuum of types. Bilateral trading relationships do not pose the existence problem that plagues the analysis of markets under hidden information.

Adverse Selection

Consider a market for goods of different quality. Sellers can observe the quality of what they sell, but buyers can only assess average quality.