Chapter%2014 - Econ 160, Vardanyan Chapter 14 Imperfect...

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Econ 160, Vardanyan 1 Chapter 14 Imperfect Information: Adverse Selection and Moral Hazard What happens when the sellers have more information about the product they are selling than the buyers (used cars) or the buyers know more about the service they are buying than the sellers (life insurance)? We know that in markets where all parties are well informed about product characteristics the equilibrium will maximize total welfare, but will this be the case when the information is imperfect? We answer these questions in this chapter. The Lemons Problem Suppose the buyers cannot distinguish between two types of used cars - “lemons” (cars with high repair costs) and “plums” (high-quality cars with low repair costs). The seller knows the quality from the experience. This market is characterized by asymmetric information – a situation in which one side of the market has better information about the product than the other . Because the buyers cannot tell the difference in quality both types of cars will be sold in the same mixed market. Mixed market is defined as a market in which products of different qualities are sold for the same price . Suppose that a typical consumer is willing to pay $2,000 for a lemon and $4,000 for a plum. Thus, if this consumer has an expectation that half of used cars are lemons and the other half are plums, s/he will be willing to pay $3,000 for a 50-50 chance of getting either a plum or a lemon. The supply of plums is given by an upper supply curve in Fig. 14.1 and the supply of lemons is equal to the lower curve. Note that unless the price of a used car is at least $2,500 no plums will be supplied. Thus, if the willingness to pay is $3,000 there will be 20 plums (point a) and 80 lemons (point b ) sold daily. However, this is not the equilibrium. The reason is because the consumers’ expectation of 50% plums and 50% lemons did not materialize, since the total of 100 used cars sold daily only 20% are plums. Thus, the expectation of the future buyers will have to be adjusted, i.e. they
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This note was uploaded on 05/27/2008 for the course ECON 160B taught by Professor Michaelvardanyan during the Fall '08 term at Binghamton.

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Chapter%2014 - Econ 160, Vardanyan Chapter 14 Imperfect...

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