Week 10 Lecture_Adverse Selection

Week 10 Lecture_Adverse Selection - Week 10 Asymmetric...

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Week 10 Asymmetric Information
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Information in Competitive Markets In lots of markets, one side of the market has better information than the other. Examples: medical services, or insurance, or used cars?
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Asymmetric Information in Markets A doctor knows more about medical services than does the buyer. An insurance buyer knows more about his riskiness than does the seller. A used car’s owner knows more about it than does a potential buyer.
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Asymmetric Information in Markets Markets with one side or the other imperfectly informed are markets with imperfect information . Imperfectly informed markets with one side better informed than the other are markets with asymmetric information .
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Asymmetric Information in Markets In what ways can asymmetric information affect the functioning of a market? Important applications: adverse selection signaling moral hazard incentives contracting.
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Adverse Selection Consider a used car market. Two types of cars; “lemons” and “peaches”. Each lemon seller will accept $1,000; a buyer will pay at most $1,200. Each peach seller will accept $2,000; a buyer will pay at most $2,400.
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Adverse Selection If every buyer can tell a peach from a lemon, then lemons sell for between $1,000 and $1,200, and peaches sell for between $2,000 and $2,400. Gains-to-trade are generated when buyers are well informed.
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Adverse Selection Suppose no buyer can tell a peach from a lemon before buying. What is the most a buyer will pay for any car?
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Adverse Selection Let λ be the fraction of peaches. 1 - λ is the fraction of lemons. Expected value to a buyer of any car is at most . 2400 $ ) 1 ( 1200 $ λ λ+ - = EV
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Case 1. Suppose λ is high such that EV > $2000. Every seller can negotiate a price between
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This note was uploaded on 09/06/2010 for the course FBE ECON2113 taught by Professor Franchsica during the Fall '09 term at HKU.

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Week 10 Lecture_Adverse Selection - Week 10 Asymmetric...

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