nlecture23 - asymmetric information - slides

nlecture23 - asymmetric information - slides - 4/11/2009...

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4/11/2009 1 Topic 10: Asymmetric Information USC Marshal Introduction • So far, we have generally assumed that market participants have had the same information available to them – No seller has had better information about the characteristics and the value of the product than the buyer and vice versa USC Marshal – Often unrealistic: • Used goods – seller knows more than the buyer • Insurance – buyer knows more than the seller • Employment – worker knows more than the firm •… Introduction • Goal: – How does such asymmetric information impact the market outcome Adverse selection – What can the market participants do to improve the USC Marshal outcome Signaling and screening
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4/11/2009 2 Adverse selection • Markets with asymmetric information tend to suffer from adverse selection : – An informed individual is more willing to trade when trading is less advantageous to an uninformed trading partner USC Marshal – Forecasting this, the uninformed partner becomes more reluctant to trade “I don't care to belong to a club that accepts people like me as members” - Groucho Marx Adverse selection Example: Suppose you are thinking about buying a used car. If the car is of high quality, it is worth $5,000 to you while if it is of low quality, it is worth $2,000 to you. The probability that the car is of high quality is p and you are risk-neutral. USC Marshal – How much would you be willing to pay for the car if the owners of both high and low quality cars are willing to sell their cars at that price? – Suppose that the owners of the high-quality cars are not willing to sell at that price. What happens? Adverse selection • Not knowing the quality of the car, the buyer attributes a probability p that it is high quality and (1-p) that it is low quality. Thus, the maximum he is willing to pay is P p 5000 1 p 2000 2000 3000 p USC Marshal • If the valuation of the high-quality seller exceeds this price, then he is unwilling to sell. The buyer knows this and is thus willing to pay only P=2000 for the car. Only the low-quality sellers sell their cars.
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4/11/2009 3 Adverse selection Logic: – As an uninformed buyer, I am worried about the quality of the good. I am only willing to pay the expected value of the car, given my expectations about which types of cars get traded in the equilibrium USC Marshal – The sellers with the highest-quality cars might be unwilling to sell at this price – Forecasting this, I reduce my willingness to pay – Which in turn might drive more sellers out of the market • This effect is known as unraveling Adverse selection Other examples: – Insurance: people with a high risk of accident find any given insurance contract (coverage, premium) more attractive than people with a low risk of accident USC Marshal • Insurance companies increase premiums to compensate for this, which drives more of the low-risk people out of the market – Employment: less able people tend to be more
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nlecture23 - asymmetric information - slides - 4/11/2009...

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