Asymmetric

UNIT 8 ASYMMETRIC INFORMATION Information

Structure

8.0 Objectives
8.1 Introduction
8.2 Asymmetric Information
8.3 Adverse Selection
8.3.1 Market for ‘lemons’
8.3.2 Market for Labour
8.3.3 Market for Insurance
8.3.4 Market for Credit
8.4 Solution to Asymmetric Information- Signalling and Screening
8.4.1 Signalling
8.4.2 Screening
8.5 Moral Hazard
8.5.1 Principal-agent Problem
8.6 Let Us Sum Up
8.7 Some Useful References
8.8 Answers or Hints to Check Your Progress Exercises

8.0 OBJECTIVES
After going through this unit, you will be able to:
x explain the concept of asymmetrical information;
x discuss how asymmetrical information leads to market failure;
x describe market solutions to the problem of asymmetric information;
x define the problem of moral hazard resulting in the presence of
asymmetric information; and
x understand principal agent problems.

8.1 INTRODUCTION
In a perfect competitive market structure, one of the key assumptions
defining the market is that of complete and symmetric information among
the parties involved in the transaction. That is, we assumed no seller knows
more about a product’s characteristics than a buyer, and no buyer knows
more about the product’s costs than a seller. Such an assumption is
unrealistic due to the fact that in real life, one party to a transaction often
has more information than another about the characteristics of the good or

Market Failure service to be traded. This condition is referred to as that of asymmetric
information.

For instance, the seller of a product usually knows more about the quality of
the good than the buyer; workers usually know more about their abilities
than the potential employers; in the market for second-hand cars, sellers
have more information regarding the true status of the car than the buyer;
in the financial market, the creditor has relatively lesser information about
the default risk of the debtor than the debtor himself; and in the health
insurance market, the insurance company has lesser information about the
health status of the individual than the individual himself. These are some of
the common examples of the presence of asymmetrical information.

As per the first welfare theorem of Economics, perfect competition leads to

a Pareto efficient allocation of resources. A key assumption for the theorem
to hold is that all the information related to the trade in the market should
be equally observed by all the agents involved. When such assumption fails
to hold, that is, when information is asymmetric with one agent possessing
more information related to the trade than other agent(s), prices are
distorted and we do not get a Pareto efficient allocation of resources. This is
referred to as the situation of market failure. The present unit will discuss
the concept of asymmetric information; how does it lead to market failure
and how equilibrium is attained in the presence of asymmetric information.

8.2 ASYMMETRIC INFORMATION

The concept of asymmetric information was first analysed by George Akerlof
in his 1970 paper titled dŚĞ DĂƌŬĞƚ ĨŽƌ Η>ĞŵŽŶƐΗ͗ YƵĂůŝƚLJ hŶĐĞƌƚĂŝŶƚLJ ĂŶĚ
ƚŚĞ DĂƌŬĞƚ DĞĐŚĂŶŝƐŵ. He considered an example of automobile market.
Asymmetric information exists, when amongst different parties in the trade,
unequal information set persists. That is, if we assume there are buyers and
sellers in the market, then under asymmetric information, one agent will
have greater (or lesser) information than the other. For example, in the
market for second-hand cars, also called the market for lemons, sellers of
the second-hand cars have more information about the real value of the car
than the buyer. This information asymmetry gives the seller an incentive to
sell goods of less than the average market quality. The average quality of
goods in the market will then reduce as will the market size. Moreover,
buyer possessing lesser information, often is discouraged to go in trade, as
he wants to reduce the risk of buying a damaged car, called a ‘lemon’. Thus
the presence of asymmetric information, may result in no trade taking place
at all. In another example, in the market for health insurance, buyer of
insurance has more information about his/her status of health than the
insurance company selling such policies. More such examples exist in the
real world. The existence and persistence of asymmetrical information
cannot be denied and due to it, many markets fail to trade. This simply
 means, that due to lack of symmetry in information between the parties,
 Asymmetric
they are unable to construct tradable price in the market and without
Information
tradable price, trade cannot take place. This way asymmetrical information
leads to market failure.

To correct for the market failure resulting from asymmetrical information,

one way out is when such asymmetries in information can be nullified, in
other words when more equal distribution of information is possible. For
instance, in markets for second-hand cars, some certification or quality
accreditation with some years of guarantee from an organisation can help
spread information about the true real value of the second-hand car
amongst buyers and sellers. In the market for health insurance, a thorough
medical check-up can reveal true status of the buyers’ health. In the
financial market for credit, borrowers borrowing-score can help reveal the
actual default rate of the borrower.

8.3 ADVERSE SELECTION

Asymmetric information exacerbates inefficiencies. One reason behind why
presence of asymmetric information leads to market failure is due to
adverse selection. Adverse selection refers to a situation when parties
gaining from the presence of asymmetric information are more likely to
enter into a trade than the parties suffering from information asymmetries.
In our examples mentioned in the previous section, if buyers of the second-
hand cars cannot distinguish good cars from bad ones, sellers may be
inclined to sell only lemons (bad-quality cars). If insurance companies have
difficulty in evaluating applicants’ health status, they may end up serving
high-health risk policyholders and may not be able to harness the cross
subsidies from the low health risk policyholders and thus may not be able to
breakeven due to high insurance claims from the high risk clients. If the
potential employers have trouble assessing the abilities of workers, they
may end up employing poorly qualified workers. In each of these examples,
the informed parties, viz. second-hand car sellers, insurance buyers,
workers, are more willing to trade when trading is less advantageous to the
uninformed parties, viz. second-hand car buyers, insurance companies, and
potential employers, respectively. This phenomenon is known as adverse
selection. When the affected uninformed parties realise that they face
adverse selection, they may become reluctant to even come forward for
trade, causing a market failure.

Let us discuss a few of these examples which lead to adverse selection and
market failure in detail.

8.3.1 Market for ‘lemons’

Let us consider a market where buyers and sellers have different
information regarding the quality of the product offered for sale. Consider a
market where there are 100 sellers and 100 buyers for used cars. Everyone
knows that all the used cars are not of same quality and there is 50 per cent 
Market Failure chance of getting a car in good condition (‘Plums’) and 50 per cent chance of
getting a car in bad condition (‘lemons’). However, the owner of the cars
know the actual quality of the car, but the buyers have no clue about which
one is plum and which one is lemon. Moreover it is not easy to verify the
quality of car from the market.

Let the owners of the lemon want to sell it at Rs. 1,00,000 and the owners of
the plums want to sell at Rs. 2,00,000. Let the buyer of the car is ready to
pay Rs. 2,40,000 if the car is a plum but Rs. 1,20,000 if the car is a lemon. If
there is no problem in verifying the quality of car from the market, then the
lemons will be sold at some price between Rs. 1,00,000 to Rs. 1,20,000 and
the plums will be sold at some price in between Rs. 2,00,000 to Rs. 2,40,000.
Since buyers cannot observe the quality of car to be purchased, they will
have to guess about the quality of an average car. Given that there is only 50
per cent chance of getting a plum (i.e., a car is equally likely to be a plum or
a lemon), the expected value of the car for a typical buyer is:
ଵ ଵ
‫ܧ‬ሺ‫ܤ‬ሻ ൌ  ଶ ൈ ʹͶͲͲͲͲ ൅  ଶ ൈ120000 = Rs. 1,80,000.

However, at that price the owner of the lemons will be only willing to sell
the car (because ‫ܧ‬ሺ‫ܤ‬ሻ ൌRs. 180000 >‫ܵ(ܧ‬௅௘௠௢௡ )ൌRs. 100000) but not the
owner of the plums (because ‫ܧ‬ሺ‫ܤ‬ሻ ൌ •Ǥ180000 <‫ܵ(ܧ‬௉௟௨௠ )ൌRs. 200000).
The price that the buyers are willing to pay for an average car is less than
the price that the sellers of plum expect from the transaction. So at a price
of Rs. 180000, only lemons would be offered for sale. Even though the price
at which buyers are willing to buy plums exceeds the price at which sellers
are willing to sell them, no such transaction for plums will take place. This is
the problem of market failure. In an extreme case, if the buyer was certain
that he would get a lemon, he would not be willing to pay Rs. 1,80,000 for it.
The equilibrium price then would have settled somewhere between
Rs. 1,00,000 to Rs. 1,20,000. For this price range market would have been
segregated, for sellers of plums would not offer their cars for sale.

There is an externality problem between the sellers of plums and lemons,

which result in the market failure. When an individual is trying to sell lemons
he affects the buyers’ perception on the quality of average car in the
market. This lowers the price that the buyers are willing to pay for an
average car in the market. This further discourages the sellers of plums. This
is an externality problem. Thus in the presence of information asymmetry, if
too many low quality items are offered for sale, it changes the buyers’
perception (and dampens the willingness to pay) on the average product,
and thus making difficult for the sellers of high quality items to offer their
products in the market.


 Asymmetric
8.3.2 Market for Labour Information

Now consider market for labour in Fig. 8.1. Let us represent the number of
workers on the horizontal axis and monthly wages on the vertical axis. The
figure shows demand curves for high- and low-ability workers when
workers’ abilities are observable to the potential employers, labelled as DH
and DL respectively. The figure also shows the supply curves for high- and
low-ability workers labelled as SH and SL respectively. The higher the
monthly wage, more the high-ability workers are willing to accept
employment.

Wages per month

SH
SL
12000 DH

6000 DL

2000

200 400 500 1000 Workers

Fig. 8.1: Market for Labour

Using this figure, we show how asymmetries exist in the labour market.
Usually workers have greater knowledge about their abilities than their
potential employer. We assume here that workers are paid according to
their abilities.

Initially we assume the ideal market situation where the potential employer
can easily differentiate between a high-ability and a low-ability worker.
Accordingly, a high-ability worker will be paid where curve DH intersects SH.
The number of high-ability worker employed will be 500 and they will be
paid a monthly wage of Rs. 12,000. The equilibrium for low-ability worker is
where curve SL intersects DL, that is, at 400 low-ability workers paid a
monthly wage of Rs. 6000 per month. Low-ability workers are paid lower
than the high-ability workers when the labour market is in equilibrium. In
this case, we do not face a situation of asymmetric information, as the
abilities of the workers to be hired are common knowledge. Thus, the
employer can easily differentiate between a high-ability and a low-ability
worker.

Now consider the case when we have a situation of asymmetric information

in the labour market. That is, the abilities of the workers to be hired are not
the common knowledge anymore. For this refer Fig. 8.2. 
Market Failure
Wages per month
SH
SL
B C
12000 DH

A E
6000 D

D
4000 DL
F

2000

300 400 500 600 900 1000 Workers

Fig. 8.2: Deadweight loss under Market for Labour

Given that there is information asymmetry, the potential employer is not

able to distinguish between the high- and low-ability workers. So for the
employer the demand for labour is depicted by the demand for an average
worker. Thus following Fig. 8.2, D represents the demand for an average
worker which is given by the average of low-ability and high-ability workers.
DH represents demand for high-ability workers and DL is the demand for
low-ability workers. Let curve S represents the total supply of high- and low-
ability workers together. Curve SH and SL are the supply of high-ability and
low-ability workers, respectively. Thus in the presence of information
asymmetry, the labour market equilibrium is defined by the intersection of
the S and D curve, depicting the total employment of labour in the
equilibrium as 900 workers. Out of 900, the existing 400 low-ability workers
should be paid a monthly wage of Rs. 4000, while the existing 500 high-
ability workers should be paid a monthly wage of Rs. 12,000. This would be
the feasible outcome when the quality of labour was observable. But since
in this case ability of labour cannot be distinguished, 900 workers in the
market are paid a uniform monthly wage of Rs. 6000. This is due to the
presence of asymmetric information to the potential employer about the
abilities of the workers. As a result of this, a high-ability worker is underpaid
and a low-ability worker is overpaid. This will discourage a high-ability
worker from participating in the labour market. At Rs. 6000 per month, only
300 high-ability workers will participate (as shown by the intersection of SH
with D curve). As low-ability workers are overpaid, they will be encouraged
to participate more in the market. So instead of 400, 600 low-ability workers
participate in the labour market in the equilibrium at the monthly wage of
Rs. 6000 (as shown by the intersection of SL with D curve).

In the market, ideally if no asymmetry in information is present, there were

total 900 workers employed, out of which 400 were low-ability and 500
high-ability workers. In the presence of asymmetric information, there 300

 Asymmetric
high-ability and 600 low-ability workers.This shows that quality of the labour
Information
in the market dropped due to the presence of the asymmetric information.
This is known as the situation of adverse selection. Potential employers
would have hired 500 high-ability and 400 low-ability workers when there
was no asymmetric information, but they ended up hiring 600 low-ability
and 300 high-ability workers. Hence, the market has become adverse due to
the presence of asymmetric information.

Deadweight loss due to asymmetric information:

In Fig. 8.2, area ABC represents the deadweight loss due to lower hiring of
high-ability workers and area DEF represents the deadweight loss resulting
from hiring too many of low-ability workers. In the above case we saw that
in the labour market equilibrium, with the presence of asymmetric
information, fraction of high-ability workers will be smaller than it would
have been in the first best scenario (without any information asymmetry)
where the potential employers would able to identify abilities of the
workers before hiring. Because of asymmetric information, low-ability
workers drive high-ability workers out of market. This phenomenon is an
important source of market failure.

8.3.3 Market for Insurance

Huge asymmetric information exists in the market for insurance. For
instance, in the case of health insurance, the maximum and true information
about one’s own health is known only to the person himself or herself. The
insurance company often suffers from the lack of information about the
person’s real health status. People facing high health or disability risk (and
old in age) would prefer buying a fat medical insurance, so that their
medical bills can be taken care of. While healthier (and younger) people
facing a lower health risk, generally do not need much insurance and hence
they would prefer to buy insurance which are attractive to them in terms of
premium and insurance cover. If the insurance company sells insurance to
proportionately more sick or old people, then it may not be sustainable for
them to run business because it won’t be able to draw the benefit of cross
subsidies from the healthy (and young) clients. The insurance company will
incur huge costs of frequent claims and may find it difficult to breakeven. In
such cases the profit maximising company may withdraw from the market.

In the presence of asymmetric information, it is difficult for the insurance

company to segregate individuals facing high health risk from the ones
facing a lower risk. This leads to the problem of adverse selection in the
market for health insurance. If the pricing or the insurance contract (defined
by the amount of yearly/monthly premiums and amount of insurance
benefit in case of sickness) is uniform for both the healthy and sick
individual, then it may induce a relatively stricter clause (over priced) for the
healthy individual and relatively easier clause (under priced) for the sick
individual. This situation is similar to ‘market for lemons’. In such a scenario,

Market Failure the healthy individuals may have disincentive to buy insurance while sick
individuals may have high incentive to buy insurance. Adverse selection will
prevail as individuals applying for insurance will now consists more of the
sick people than healthy people, leading to insurance company losing out
profits. This will lead to market failure in insurance market.

8.3.4 Market for Credit

Similar problem of asymmetric information exists in the market for credit. In
market for credit, the borrower has more information about his true credit
worthiness as compared to the lender. In other words, it is often difficult for
the lender to judge the true credit worthiness of the client. Choosing a
wrong client would mean greater risk of default and hence larger losses to
the lender. As in the case for market for ‘lemons’, low quality or risky
borrowers are more likely to enter the credit market for credit than high
quality or safe borrowers. This forces the lending interest rates based on the
average default risk to go up further, which in turn may induce the safe
borrowers to withdraw from the market and may increase the client profile
of lenders by more risky borrowers. This leads to the problem of adverse
selection in the credit market.

8.4 SOLUTION TO ASYMMETRIC INFORMATION-

SIGNALING AND SCREENING
8.4.1 Signalling
The existence of asymmetric information often leads to the problem of
adverse selection and this leads to market failure. Now what to do when
asymmetric information is prevalent? One way in which the buyer and seller
can deal with this problem is through market signalling. The concept of
market signalling is where the buyer or the seller signals the other
uninformed party, to increase their information about the product in trade.

To see how market signalling works, let us consider the case of asymmetric
information in the labour market. In the labour market where high- and low-
ability workers are present and are not easy distinguishable, employing
somebody can be very costly to the potential employer. If an employer hires
a low-ability worker for a job requiring high-ability, he will be in severe loss.
In such a case ŵĂƌŬĞƚ ƐŝŐŶĂůůŝŶŐ works great. The high-ability worker can
signal the employer about his abilities, which stand out amongst all the
other low-ability candidates. Signals could be in the form of better resume,
being highly qualified, education level, showing good etiquettes, speaking in
decent language, etc. These mechanisms are often used by the high-ability
worker to signal the potential employer about his (her) potential and makes
sure the employer credit him (her) with a high quality tag.


 Asymmetric
8.4.2 Screening Information

Presence of asymmetric information provides incentives to the parties

concerned to communicate with each other. In the previous sub-section we
came across how informed parties (workers) provide information to the
uninformed parties (the potential employer) to make up for the
asymmetries in the information. There, the informed parties initiate
communication by signalling about their hidden type to the uninformed
parties. There is another way to take care of the information asymmetries,
which is when uninformed parties initiate communication by conducting a
test either for the informed parties or the goods those parties seek to trade.
For instance, in the market for second-hand cars, the potential buyer of a
second-hand car can learn about its quality by getting it checked from a
mechanic or learn about the accident record of the car. Similarly, a life
insurance company can gain information regarding the health of an
insurance policy applicant by obtaining the applicant’s medical records,
contacting his current physician, or subjecting him to a physical
examination. Another common way of implementing screening is by
designing and offering different contracts for the different types of agents
with hidden information, instead of offering one homogenous contract. In
this way each agent’s type gets revealed.

There is one significant difference between signalling and screening. In

signalling it is the more informed party that initiate the communication,
whereas in screening the communication intended to make up for the
information asymmetries is initiated by the less informed.

Check Your Progress 1

1) Define asymmetrical information? How does asymmetrical information

lead to market failure?

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2) How does ŵĂƌŬĞƚĨŽƌůĞŵŽŶƐ turn into adverse selection?

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Market Failure 3) What is solution to the problem of adverse selection?

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8.5 MORAL HAZARD

Moral hazard is also a result of asymmetric information where asymmetry
arises due to hidden action by agents such that the action of one party is not
observed by the other party in trade, which in turn affects the benefits of
the latter. For example, in the case of the insurance market, an insured
individual’s risk of death or disability may increase in the post insured stage
because of his unhealthy lifestyle including smoking, excessive drinking, or a
lack of exercise. However, the insurance company is likely to have difficulty
in monitoring his behaviour and adjusting its premiums accordingly.

Moral hazard often arises in the labour market since employers cannot
monitor the behaviour and efforts of their employees completely. This
causes inefficiency with employees exerting less effort than the employer
would consider required. Moral hazard is also prevalent in big corporations,
where individual managers may take actions that further their own interests
at the expense of the company, which we discuss in the next section. In
general, moral hazard occurs when a party to a transaction takes hidden
actions that remain unobserved by its trading partner and that affect the
benefits or payoff of the latter.

A simple illustration explaining moral hazard associated with asymmetric

information problem and how it leads to increase in the costs is as follows.
Consider a case of night security guard in a company. Since the duty is for
the night, nobody observes the actions of the security guard. This in turn is
incentive enough for the guard to shirk, that is, not guarding properly.
Suppose he frequently sleeps during his duty hours as he knows his actions
are not observed. As a result of this, one night the company suffers a break-
in, leading to huge costs to the company. This is due to the presence of
moral hazard in the guard’s hidden behaviour which the firm is unable to
observe. Thus the presence of asymmetric information leads to market
failure.

8.5.1 Principal-agent Problem

We often study a simplified model with only one agent on either side of the
market to understand asymmetric information problems. The agent who
 proposes the contract is called the principal and the agent who either
 Asymmetric
accepts or rejects the contract is called the agent. The existence of moral
Information
hazard too occurs because of the principal and agent. Agents are the
individuals employed by the principal to achieve principal’s objective. In the
presence of information asymmetries, often preferences of the principal and
agents are not aligned and agents tend to pursue their own goals rather
than the goals of the principals. For instance, the employee (or the agent)
on duty has incentive to shirk effort, which his employer (or the principal)
fails to observe.

Common examples of a principal-agent relationship include corporate

management (agent) and shareholders (principal), politicians (agent) and
voters (principal), or brokers (agent) and markets— buyers and sellers
(principals). Consider a legal client (the principal) wondering whether their
lawyer (the agent) is recommending protracted legal proceedings because it
is truly necessary for the client's well-being, or because it will generate
income for the lawyer. Similarly a surgeon advising a patient for an
expensive knee replacement surgery may be because of genuine
requirement of the patient or because it is profitable for the surgeon. In fact
the problem can arise in almost any context where one party is being paid
by another to do something with the agent having a small or non-existent
share in the outcome.

Moral hazard problem arises where parties have different interests

and there exists information asymmetries with agent having more
information than the principal. In such a case, principal cannot directly
ensure that agent is acting in their (the principal's) best interest, particularly
when activities that are useful to the principal are costly to the agent, and
where elements of what the agent does are costly for the principal to
observe. Often, the principal may be sufficiently concerned at the possibility
of being exploited by the agent that they choose not to enter into the
transaction at all, when it would have been mutually beneficial: a
suboptimal outcome that can lower welfare overall. The deviation from the
principal's interest by the agent is called agency costs. Principal-agent
problem can be found both in private enterprises and public enterprises.
One way to correct for the principal-agent problem is by making an effective
incentive mechanism, wherein the agent can be tied with some share in the
profits so that the agents and the principal’s objectives are aligned together.
For example, giving managers (agents) some share in the company’s equity
so that they do not shirk on their full potential in their duty.

Check Your Progress 2

1) Define Moral hazard. What does it lead to?

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Market Failure 2) What is meant by the principal-agent problem? What leads to principal-
agent problem? How can that be corrected?

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8.6 LET US SUM UP

The present Unit discussed the market condition when one of the key
assumptions of perfect competition given by full and symmetric information
among the agents involved in trade does not hold. Asymmetric information
exists when in a two-party trade one party has greater information than the
other party.It leads to market failure with one reaching an inefficient
allocation of resources. Such an inefficient solution results due to adverse
selection that arises when there exist asymmetric information. In adverse
selection the high quality goods or worker leave the market and market
essentially consists of low quality goods or workers. Examples of markets
suffering from asymmetric information are— market for used cars, health
insurance market, market for credit, market for labour, etc. There is
deadweight loss to the society in the presence of asymmetric information,
as efficient allocation of resources is not happening. One solution to achieve
equilibrium in the presence of asymmetrical information is through market
signalling or screening. The Unit proceeded with describing the problem of
moral hazard that exists when one agent tries to shirk as the other agent is
not able to observe former’s actions. In such a case the agent pursue his/her
own goals rather than the goals of the principal.

8.7 SOME USEFUL REFERENCES

x Mankiw, N. G, Principle of Microeconomics, (2007) 4th edition,
Thomason Higher Education , USA
x Bernheim B.D and Whinston M.D, , Microeconomics, (2009), Tata
MacGraw Hill, New Delhi
x Varian H.R, Intermediate microeconomics, (2010), W.W. Norton and
Company,
x Stiglitz J.E and Walsh C. E, Principles of microeconomics (2010), W.W.
Norton and Company


 Asymmetric
8.8 ANSWERS OR HINTS TO CHECK YOUR PROGRESS Information
EXERCISES
Check Your Progress 1

1) Refer Sections 8.2 and 8.3 and answer

2) Refer Sub-section 8.3.1 and answer
3) Refer Section 8.4 and answer

Check Your Progress 2

1) Refer Section 8.5 and answer

2) Refer Sub-section 8.5.1 and answer


Market Failure
GLOSSARY

Constant Returns : Constant Returns prevails when the

proportionate increase (decrease) in input(s)
leads to the increase (decrease) in output in
the same proportion.
Contract Curve : It is the locus of the tangency points of the
isoquants representing the two goods in the
Edgeworth box.
Diminishing Returns : Diminishing Returns prevail when the
proportionate increase (decrease) in all the
input(s) results in the less than proportionate
increase (decrease) in output.
Efficiency : The economic state in which all the resources
are optimally employed and all economic gains
are fully exhausted such that any change to
assist someone will harm another.
Full Employment : Is a condition when all the productive
resources of the economy are fully employed.
Equity : The state of distribution where all agents get
the equitable share of the pie.
First Welfare : The first welfare theorem ensures that a
Theorem perfect competitive equilibrium is Pareto
efficient.
General Equilibrium : General equilibrium theory explains the
functioning of economic markets as a whole. It
is concerned with the equilibrium in all the
markets simultaneously.
Increasing Returns : Increasing Returns prevails when the
proportionate increase (decrease) in all the
input(s) results in the more than proportionate
increase (decrease) in output.
Isoquant : An isoquant shows different combinations of
two inputs that can produce a constant level of
output.
Marginal Rate of : Slope of an isoquant. It gives the amount at
Technical Substitution which one input is reduced for an additional
unit of another input while producing the same
level of output.
Pareto : It is the state of allocation of resources such
Efficiency/Optimality that no one can be made better off without
making someone else worse off.
Pareto Inefficient : State of resource allocation such that there is a
possibility to make someone better off without
making anyone else worse off.

 Asymmetric
Partial Equilibrium : Partial equilibrium explains the concept of
Information
economic equilibrium of a single market,
holding all other factors and markets constant.
Perfect competition : It is a market form with large numbers of
informed buyers and sellers all of whom are
price takers.
Production : Given the resources and the state of
Possibility/ technology, it depicts different combinations of
Transformation curve two goods that can be produced by fully and
efficiently employing all the resources of the
economy.
Second Welfare : Second welfare theorem states that any Pareto
Theorem efficient allocation can be rationalised as
competitive market equilibrium.
Aggregation of : It is the way of depicting individual
Preferences preferences into social preferences.
Benthamite Social : It is a social welfare function which is derived
Welfare Function from aggregation of individual utility functions.
It is represented as ܹሺ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሻ ൌ σ௡௜ୀଵ ‫ݑ‬௜
Bergson-Samulseon : Also known as individualistic welfare function,
Social Welfare it is given by ܹ ൌ ܹሺ‫ݑ‬ଵ ǥ Ǥ Ǥ ǡ ‫ݑ‬௡ ሻ, where ‫ݑ‬i
Function (with ŝ = 1…Ŷ) represent individual utility
functions which are ordinal and are a function
of whatever it may be that provides individuals
with utility or satisfaction.
Efficiency in Product : It refers to Pareto efficiency in production and
Mix exchange.
Isowelfare Curve : The curve depicts combination of utility of two
individuals which gives same level of welfare.
Overall Efficiency : It means efficiency in product mix. A Pareto
efficient allocation in production and
exchange.
Rawlsian Social : It is also known as Minimax social welfare
Welfare Function function:
ܹሺ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሻ ൌ ‹ሼ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሽ.It takes
into consideration welfare of the worse off
agent.
Social Welfare : Social welfare function is the aggregation of
Functions individual utility functions. It depicts social
welfare as a function of individual preferences.
Utility Possibility Set : Utility possibility set depicts the utility set of
two individuals.
Utility Possibility : The curve or the boundary of utility possibility
Frontier set is known as utility possibility frontier. It
consists of all Pareto efficient allocations.

Market Failure
Value Judgements : It refers to the concept of beliefs of individuals
about what is good and what is bad.
Welfare Economics : It is a branch of economics which is concerned
with the overall social welfare of the economy.
It aims at developing economic policies and
target different welfare problems and issues.
Value judgement plays an important role in
welfare economics.
Consumer Surplus : Difference between the total amount
consumers are willing and able to pay for a
good and the total amount that they actually
pay.
Deadweight Loss : A loss of economic efficiency that is generated
by an economically inefficient allocation of
resources within the market.
Economies of Scale : Cost advantage in terms of fall in the long-run
average cost experienced by a firm when it
increases its scale of production.
Inverse Demand : Inverse of demand function expressed in the
Function form of price as a function of quantity
demanded P(Q).
Lerner’s Index : A measure of monopoly power, it measures
௉ሺொሻିெ஼
the price-cost margin, as is given by ௉ሺொሻ

Natural Monopoly : Occurs when one firm (because of possession

of unique raw material, technology, or other
factors) can supply market's entire demand for
a good or service more efficiently than two or
more firms can.
Price Discrimination : A pricing strategy which involves charging
different consumers different prices for the
identical good or service.
Price Elasticity of : A measure of responsiveness of demand for a
Demand product to its own price.
Producer Surplus : Difference between the amount the producer
is willing to supply goods for and the actual
amount received by him.
Allocative Efficiency: : Efficiency resulting when resources are
allocated in such a manner that society is as
well off as possible. This results when output
is produced to the point where the marginal
benefit to society from a unit just equals the
marginal cost of producing that unit. Perfect
competition ensures allocative efficiency by
producing where price equals marginal cost,
 whereas under both monopoly and
 Asymmetric
monopolistic competition, price is marked-up
Information
over marginal cost due to which allocative
efficiency is not ensured.
Deadweight Loss : The loss of social welfare measured in terms
of the sum of producer and consumer surplus
when the equilibrium outcome is not
achievable or not achieved. Both monopoly
and monopolistic competition create
deadweight loss by producing lower output
and charging a higher price than what a
competitive market would produce and
charge.
Economic Profit : Difference between a firm's total revenue
and the sum of its explicit and implicit costs,
also called the supernormal profit.
Excess Capacity : A distinctive feature of monopolistic
competition, it is given by the increase in the
current level of output that is required to
reduce unit costs of production to a
minimum.
Imperfect : Competition is said to be imperfect when one
Competition or more characteristic features of a perfect
competition (viz. homogeneous products,
many sellers and buyers, perfect information,
no barriers to entry and exit, no government
intervention) does not hold.
Incumbent Firm : A firm which is already operating in a market.
Minimum Efficient : The output level at which the internal
Scale economies of scale have been fully exploited
so that the long-run average cost is
minimised. It is also known as the output
range over which a producer achieves
productive efficiency.
Non-price Competition : Sellers competing on factors other than price,
which include, aggressive advertising,
product innovation, better distribution, after-
sale services, etc.
Normal Profits : Also called zero economic profit, it equals the
difference between the firm’s total revenue
and total cost.

Productive Efficiency : Efficiency achieved when production is

undertaken without waste, that is, at the
minimum cost. Perfect competition ensures 
Market Failure productive efficiency, while both monopoly
and monopolistic competition do not.
Selling Cost: : Expenses incurred for promotion of a
differentiated product and increasing the
demand for it.
Cartel : A direct formal agreement among competing
Oligopolist with the aim of maximising joint
profit and reducing uncertainty.
Collusion : An agreement whether explicit or tacit
among the rival firms to coordinate on
various accounts such as price, market share,
etc.
Dominant Firm : A firm which accounts for a significant share
of a given market than its next largest rival.
Fringe Firms : Group of firms where each firm possess an
insignificant market share and are therefore
price takers.
Nash Equilibrium : Mutually best response strategy, where each
player is doing the best it can given the
strategies of all the other players, so that
nobody has a unilateral incentive to deviate
from their own strategy.
Oligopoly : A market structure characterised by a small
number of firms that operate with a lot of
interdependence.
Reaction Curve : Also called best-response function, is the
locus of optimal (profit-maximising) actions
that a firm may undertake for any given
action chosen by a rival firm.
Tacit Collusion : Collusion where rival firms agree upon a
certain strategy without putting it in as a
formal agreement or spelling out the strategy
explicitly.
Backward Induction : A method to solve for a subgame perfect
Nash equilibrium. Under this method, we
start with solving for the optimal strategy at
the "end" of the game tree, and work "back"
up the tree.
Dominant Strategy : A strategy for a player that yields the best
payoff no matter what strategies the other
players choose.
Dominant Strategy : Dominant strategy equilibrium results when
Equilibrium every player has a unique best strategy,
independent of the strategies played by
others.

 Asymmetric
Dominated Strategy : A strategy for a player that is outperformed
Information
by another strategy which is at least as good
no matter what other players choose.
Game Tree : A directed graph whose nodes indicate
players making a choice. Branches originating
from the node indicate a particular choice
made by a player. At the end of the tree we
have the associated payoffs.
Mixed Strategies : A probability distribution that assigns to each
available action a probability of being
selected.
Nash Equilibrium : Mutually best response strategy. It is the set
of strategies, such that no player has
incentive to deviate from his or her strategy
given what the other players are doing.
Sequential Move Game : A game in which players act at well-defined
turns, and have some information on what
the other player(s) did at previous turns.
Simultaneous Move : A game in which all players act at the same
Game time, and thus have no information on the
actions of the others in the same turn.
Subgame : A subset of a game that includes an initial
node (independent from any information set)
and all its successor nodes.
Subgame Perfect Nash : A strategy profile which is a Nash
Equilibrium equilibrium of every subgame of the original
game.
Arrow’s Impossibility : As per Geanakoplos, according to the Arrow’s
Theorem impossibility theorem, “Any constitution that
respects transitivity, independence of
irrelevant alternatives and unanimity is a
dictatorship.”
Coase Theorem : Developed by Ronald Coase, as per this
theorem, in the presence of externalities,
existence of proper property rights with the
parties involved lead to an efficient outcome
regardless of which party owns the property
rights, as long as the transaction costs
associated with bargaining are negligible.
Externality : A cost or benefit of an economic activity
experienced by an unrelated third party.
Free-rider Problem : A type of market failure that arise when an
individual may be able to obtain the benefits
of a good without contributing to the cost of
it provision.

Market Failure
Logrolling : Agreeing to trade votes and support each
other’s favoured initiatives.
Marginal Private Cost : Change in the producer's total cost resulting
(MPC) from the production of an additional unit of a
good or service.
Marginal Social Cost : Sum of marginal private cost faced by
(MSC) producers of the good and the marginal
external cost faced by the party not involved,
such as environmental or social costs, arising
from a good’s production.
Market Failure : An economic situation defined by an
inefficient allocation of goods and services in
the free market.
Non-excludable Good : A good for which it is not possible to prevent
consumers who have not paid for it from
having access to it.
Non-rival in : A good whose consumption by one
Consumption Good consumer does not prevent simultaneous
consumption by other consumers.
Public Goods : Goods that are both non-excludable and non-
rivalrous in that individuals cannot be
excluded from using it, and where use by one
individual does not reduce availability to
others.
Social Choice Theory : The study of collective decision processes
and procedures.
Adverse Selection : Originally defined in the insurance theory, to
describe a situation where the information
asymmetry between policy-holders and
insurers leads to a situation with policy-
holders claiming losses that are higher than
the average rate of loss considered to set
premiums.
Asymmetric : Occurs when one party to an economic
Information transaction possesses greater material
knowledge than the other party.
Market for Lemons : In America, ‘lemon’ is used as a slang
denoting a bad quality car. In the presence of
asymmetric information, bad cars tend to
drive out good cars from the market, leaving
behind a Market for lemons (bad cars).
Moral Hazard : A situation arising as a result of asymmetric
information in which one party gets involved
or consider entering in a risky event after it
has struck a deal involving covering of the
 risky situation by the other party.
 Asymmetric
Principal-agent : Arises when one party (principal) delegates
Information
Problem an action to another party (the agent), and
there exists information asymmetries
between them.


 
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1) Hal R Varian, Intermediate Microeconomics, a Modern Approach, W.W.
Norton and Campany/Affiliated East-West Press (India), 8th Edition,
2010.
2) C. Snyder and W. Nicholson, Fundamentals of Microeconomics,
Cengage Learning (India), 2010.
3) Salvatere, D. Microeconomic Theory, Schaum’s Outline Series, 1983.
4) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Microeconomics, An imprint of Pearson Education.
5) Case, karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
6) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi

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