Asymmetric Information

Asymmetric Information - Asymmetric Information In purely...

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Asymmetric Information In purely competitive markets all agents are fully informed about traded commodities and other aspects of the market. What about markets for medical services, or insurance, or used cars? 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 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 . In what ways can asymmetric information affect the functioning of a market? ADVERSE SELECTION Consider a used car market. Type types of cars: "lemons" and "peaches." Each lemon seller will accept $1000; a buyer will pay at most $1200. Each peach seller will accept $2000; a buyer will pay at most $2400. If every buyer can tell a peach from a lemon, then lemons sell for between $1000 and $1200, and peaches sell for between $2000 and $2400. Gains from trade are generated when buyers are well informed. Suppose no buyer can tell a peach from a lemon before buying. What is the most a buyer will pay for any car? Let q be the fraction of peaches. 1-q is the fraction of lemons. Expected value to a buyer of any car is at most EV = $1200 (1-q) + $2400 q Suppose EV > 2000. Every seller can negotiate a price between $2000 and EV (no matter if the car is a lemon or a peach). All sellers gain from being in the market. Suppose EV < $2000. A peach seller cannot negotiate a price above $2000 and will exit the market. So all buyers know that remaining sellers own lemons only. Buyers will pay at most $1200 and only lemons are sold. Hence "too many" lemons "crowd out" the peaches from the market. Gains from trade are reduced since no peaches are traded. The presence of the lemons inflicts an external cost on buyers and peach owners.
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How many lemons can be in the market without crowding out the peaches? Buyer will pay $2000 for a car only if EV = $1200 (1-q) + $2400 q ≥ $2000 which implies q ≥ 2/3. So if over 1/3 of all cars are lemons, then only lemons are traded. A market equilibrium in which both types of cars are traded and cannot be distinguished by the buyer is a pooling equilibrium . A market equilibrium in which only one of the two types of cars is traded, or both are traded but can be distinguished by the buyers, is a separating equilibrium . What if there is more than two types of cars? Suppose that car quality is uniformly distributed between $1000 and $2000, and any car that a seller values at $x is valued by a buyer at $(x+300). Which cars will be traded? The expected value of any car to a buyer is $1500 + $300 = $1800. So
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Asymmetric Information - Asymmetric Information In purely...

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