Chapter 6. Uncertainty and Imperfect Information in Markets

This chapter deals with uncertainty and incomplete information in markets. It first considers situations in which the contract proposer is the ignorant party with the problem of designing a mechanism that induces the counter party, who is exogenously endowed with his information, to reveal that information in such a way that maximizes the contract proposer’s expected payoff. In contrast to settings of symmetric information, inefficiencies will tend to arise in equilibrium. Also considered is the situation when each side of the transaction is endowed with his or her own payoff-relevant information. Here the focus is on whether and how a social planner could design a contract to achieve efficiency. The following section assumes it is the contract proposer who is endowed with the payoff-relevant information. The quintessential example of this is a seller who knows the quality of the good she seeks to sell. Because she cannot commit fully to not deceive her counter party, inefficiencies arise. The last section examines the problems that arise if the asymmetry of information arises endogenously, because one party’s prior-to-trade actions provide him or her payoff-relevant information.