Econ 4010 Lecture 18

Econ 4010 Lecture 18 - 17 Markets with...

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<Lecture 18> 17. Markets with Asymmetric Information We have so far assumed that consumers and producers have complete information about the economic variables that are relevant for the choices they face. Now we will see what happens when some parties know more than others – i.e., when there is asymmetric information. - A seller of a product knows more about its quality than the buyer does. - Workers usually know their own skills and abilities better than employers. - Business managers know more about their firms' costs, competitive positions, and investment opportunities than do the firms' owners. Asymmetric Information is where one person has economically relevant information that another person does not have. Example: When a person buys medical insurance, the insuring company does not know whether the person is healthy. Nor does it know how well he is going to take care of himself after buying insurance. The former type of asymmetric information is called a hidden type problem, or adverse selection problem. The latter type of asymmetric information is called a hidden action problem, or moral hazard problem. Adverse Selection Adverse selection arises when products of different qualities are sold at the same price because buyers (and sometimes sellers too) are not sufficiently informed about the qualities of the products. As a result too much low quality products and too little high quality products are sold in the market place. - Used Car Market (Lemons $4,000, Cherries $8,000) Sellers know whether their cars are lemons or cherries but may not reveal that information to potential buyers. If buyers cannot distinguish between lemons and cherries, what is the likely outcome? Buyers knowing that there is a 50% chance that the car s/he buys is a cherry offers $6000. Given that price ($6000), sellers of cherries withdraw their products from the market. As a result only lemons will be sold in the market. - Auto Insurance Drivers have better information about their driving habits than the insurance providers. Insurer wants a diverse group of customers to spread out the costs, but face greater demand from risky drivers. As a result, Insurer raises the premium. In response, careful drivers reduce their coverage (or quantity of insurances). As a result, Insurers are left with more risky drivers. - Market for Credit Credit card companies or Banks cannot distinguish between good and bad borrowers but must charge the same interest rate to all. This attracts lower quality borrowers and as a result banks must raise interest rates. - Health Insurance An illness costs $100,000 / episode. Two types of people, with the following characteristics: Type % of Population Risk of Illness Willingness to pay Healthy People 90% 1/1000 $200 “Sick” People 10% 1/100 $1,500 1
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We calculate the cost to insure each group of people, assuming there is a large population, and the insurance company can spread out the risk. So the average cost to insure healthy people is: (1/1000)$100,000 = $100.
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Econ 4010 Lecture 18 - 17 Markets with...

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