If Adam Smith's invisible hand would work under any circumstances, economists would have had a different and probably boring life. The first fundamental theorem of welfare economics tells undergraduate students that any competitive equilibrium generates a Pareto optimal allocation of resources in the economy. As soon as one realizes that Pareto optimality is maybe not the best criterion as it allows, for example, strong inequalities among the agents in an economy a natural question is to think about other criteria for how to allocate the gains of economic processes which lead to the second fundamental welfare theorem. (Un)Fortunately, a brief look below the surface of the first welfare theorem reminds the economist of the if in the beginning of the story of Adam Smith's invisible hand. The assumptions of the first fundamental theorem of welfare economics are disregarded not only by undergraduates, but also by practitioners, politicians and even critics of economics as a science. As Greenwald (1986) put it: ''It has not, however, been widely recognized that the distortions that arise in economies in which there is imperfect information and incomplete markets - for practical purposes, all economies - result in being there real welfare consequences [.]. As a result, economies in which there are incomplete markets and imperfect information are not, in general, constrained Pareto efficient.'' This citation directly addresses the two sources of failure of the first welfare theorem where this book tries to shed some light on the matter - Imperfect Information and Incomplete Markets.
Two essays are dedicated to topics related to imperfect information in markets for experience goods. The market mechanisms under study to overcome this shortfall are Signaling and Certification. In the first case we study a new channel of how to transmit information on unobserved characteristics of a given product to uninformed consumers. This channel is the offer of a full product line which consequently allows for a standard price signal. Thereby the monopolist bypasses the well-known moral-hazard problem of quality procurement. In the second case the market mechanism is third-party certification. By credibly assessing relevant information the information intermediary reduces the information asymmetries and allows quality-based pricing. We answer the question on which side of the market such a third party should offer its service. This question is not only of theoretical interest as in the aftermath of the financial crisis in 2007 rating agencies were blamed for providing biased information which was related to the issuer-pay model. As a result we get that even from a welfare-perspective this selling strategy may be optimal in many instances.
One essay is dedicated to a search and matching problem in incomplete markets. In the context of a marriage market model with search frictions we analyze the impact of horizontal heterogeneity among agents on the observed outcome. Contrarily to most parts of the literature agents do not share their preferences for the potential spouses from the other side of the market. Personal preferences such as taste for music or simply regional preferences determine the outcome of the matching process. This generalizes the standard literature as it allows for individual preferences of the spouses. As a result the princess sometimes marries the frog which is more or less impossible in a model without this type of heterogeneity. The setup of the model and its partially surprising outcomes may serve as a workhorse for future research on matching markets. For practitioners the results may for example indicate that for the improvement of the well-being of poorly educated people it is better to educate people more intensely than to improve the effectiveness of the matching institution which is in this case the organization of the labor market.