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Adverse+Selection+Notes - Economics 395 Risk and...

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Economics 395 Risk and Uncertainty Asymmetric Information and Adverse Selection Class Notes 1. Introduction The main aim of these notes is to introduce the idea that informational asymmetries can cause market failures. Classic results about the efficiency of competitive markets rely on many conditions being satisfied. Importantly, the perfectly competitive market typically assumes agents are endowed with full information about the environment in which they operate. While full information is not of overwhelming importance, the symmetry of the information distributed is. In these notes we will see examples of how asymmetric information will generate inefficient outcomes in the market. The common element in these examples is the inability of some market participants to observe the nature or “type” of their trading partners. 1 This leads to ambiguity in the way the trading partner’s actions are interpreted, and so generates risks for the agents that distort the market from efficient outcomes. Such models are known as “hidden type” problems, or “adverse selection” problems (indicating the similarity with a canonical problem observed in insurance markets). We will investigate two basic models in this set of notes. First, Akerlof’s model of the used car market (i.e. the “market for lemons”) is presented, as it is perhaps the simplest adverse selection model, and serves as a template for how we discuss other similar, but more complex models. The second model we discuss is the classic insurance model of Rothschild and Stiglitz, which presents a coherent approach to deal with adverse selection issues in insurance markets. Developing this model will also require an introduction to the state-contingent income model. 2. Akerlof’s Market for Lemons A consumer wishes to buy a used car, but realizes that not all used cars are of equal quality. For simplicity, assume that there are just two types of used cars: high quality cars (“peaches”) and low quality cars (“lemons”). The buyer’s reservation price for a peach is V H and for a lemon is V L < V H . The sellers also have reservation prices, which we will label v H and v L respectively. We assume that sellers appreciate the difference in the value of their cars, and that v H > v L ; that trade in either type of car is beneficial (i.e. trade in either car will actually increase social surplus, so that V L > v L and V H > v H ); and that the efficient trading arrangement involves the buyer purchasing a peach (i.e. there is more surplus available from trading a peach than a lemon, so that V H – v H > V L – v L ). Clearly, if a seller is aware of her own reservation price, then she must be aware of which type of car she possesses. And if information in this market is symmetrically distributed, 1 The literature has characterized this as uncertainty over the trading partner’s preferences.
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then buyers will also know this information. This is essentially a full information environment. We anticipate that such a market will generate the efficient outcome:
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Adverse+Selection+Notes - Economics 395 Risk and...

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