Studies in Pricing Under Asymmetric Information

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  • On February 20th, Teemu Pekkarinen will defend his doctoral dissertation “Studies in Pricing Under Asymmetric Information.”

    Pekkarinen’s dissertation consists of three independent studies. Each paper contributes to the theory of information economics, which focuses on strategic behavior of agents who do not know each other's objectives. Each study suggests a simplified but coherent perspective on pricing under asymmetric information.

    The first study analyzes the incentives of advertising firms. The empirical advertising literature suggests that heavily advertised brands are more expensive than less-advertised goods within the same class of goods. This phenomenon has usually been explained by persuasive advertising that alters consumers' tastes and brand loyalty. We, however, show that this positive relationship between prices and advertising is a natural feature of informative advertising, too. That is to say, the sellers who advertise more aggressively can ask high prices since with positive probability they capture buyers who lack information about lower prices in the market.

    To be more specific, we find that in equilibrium the sellers use mixed strategies in pricing, which leads to price and advertisement distributions. With convex advertising costs, each seller sends only one advertisement in the market. We delineate a class of advertising costs that ensures sellers may send multiple advertisements in equilibrium. That is, if the advertising costs belong to this class of concave cost functions, higher prices are advertised more than lower prices.

    In the second study, we examine an institution design such as the procurement of goods, services, and works by a public authority or selling rights to do business. We consider a regulator who can decide whether to allocate the right to conduct a business to a firm who has private information about its profitability, emissions, or some other verifiable parameter. The results of earlier literature all culminate in the optimal policy to sell the rights is to make a specific price offer for the buyer such that she receives information rent – that is, the buyer pays a lower price than she would have received if she did not have an information advantage. If there are many potential buyers, the optimal selling procedure can be implemented by a second-price auction with a reserve price. Similarly, in this case, the winner of the auction receives the object with a lower price than he or she was willing to pay.

    We diverge from the approach of earlier literature by assuming that the regulator has the power to punish the firm with a fine if the firm is caught being non-compliant (e.g., tax evasion or accounting fraud). In order to verify the firm's compliance, the regulator has to invest in costly monitoring. Moreover, we suppose that a firm can weaken the regulator's monitoring efforts by covering up its misreporting by engaging in costly 'avoidance' (e.g., by falsification of accounts, corruption, or bribing).

    We design the optimal regulatory policies with and without avoidance. While a take-it-or-leave-it offer is the optimal mechanism without enforcement, non-linear pricing is the optimal mechanism with enforcement. The rationale for this result is that the principal is able to extract a proportion of the agent's information rent by monitoring and fines. Avoidance has two implications for the optimal regulatory mechanism: (i) the expected optimal transfers to the principal decrease and (ii) the principal allocates the object to a smaller share of buyers. If the latter effect dominates the former, it is possible that the agent's capability to engage in avoidance is disadvantageous not only for the principal but also for the agent ex ante. In summary, effective enforcement by the institution designer increases efficiency so that the rights are allocated more frequently and the gains from the allocation for the institution designer increase.

    In the third study, we also analyze a mechanism or institution design in a bilateral trade setup. Mechanism design by an informed principal studies contracting problems where the principal has some private information about the object that she is allocating to agents. This kind of asymmetric information structure is present in many economic circumstances; practically almost all firms or sellers have some relevant information about their products that their customers or buyers do not know. For example, if a car owner is selling her used car, she may want to conceal the information about the car's quality from potential buyers. However, the seller's choice of how to sell the car may still signal something about her private information to the buyers. Thus, the seller faces the following dilemma: How to optimally choose a selling mechanism that may reveal some substantive information to buyers?

    In the seller-optimal (safe) mechanism, the seller commits to a non-linear pricing scheme. This is due to the signaling motives of an informed seller; a seller whose goods are highly valuable to the buyer can disclose the quality of the goods by decreasing the supply and asking high prices. That is, a high-quality seller wants her goods to be scarce and expensive and a low-quality seller abundant and cheap. In this way, sellers can differentiate their products from each other and maximize their payoffs. We extend this model to two-sided private information and give a novel characterization of the seller-optimal mechanism in this setup. It turns out that if there is two-sided asymmetric information, then the seller finds it optimal to engage in price signaling instead of quantity signaling. This is the least-cost way for the seller to signal her private information to the buyer.

    The main takeaway of this paper is to show that the private information of the seller (or the mechanism designer) leads to a deadweight loss or inefficiency, making both parties worse off than in the case where the seller was not informed. And if there is private information also on the buyer’s side, this makes the allocation even more inefficient.

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    Teemu Pekkarinen

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