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Lecture 15 - Chapter 12 Economics of Information Lecture 15...

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10/28/10 1 Lecture 15 The Economics of Information: Adverse Selection Moral Hazard Chapter 12: Economics of Information A. Probabilities B. Expected value C. Risk aversion D. Value of information E. Asymmetric information Suppose that 90% of the cars that are manufactured work as they’re supposed to But 10% of the cars are “lemons” (constant and expensive repair bills) Suppose you can’t determine whether a car is a “lemon” just by looking at it. Let’s say the value of a good used car to you is $10,000. But the value of a lemon to you is only $6,000. Question: how much are you willing to pay to buy a used car? Calculations of buyer If: 90% of the used cars for sale are good (worth $10,000) 10% are lemons (worth $6,000) you are risk neutral then: you’d be willing to pay (0.9 x $10,000) + (0.1 x $6,000) = $9,600 for a used car Calculations of seller Seller (unlike the buyer) knows whether she has a lemon Buyer offers $9,600 If car is good, it’s worth $10,000, seller wouldn’t want to part with it for $9,600 If car is lemon, great idea to sell it
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10/28/10 2 Resulting equilibrium: only lemons are sold on the used car market Key feature that produced this phenomenon: asymmetric information Seller knows quality of car, buyer does not Markets can fail to function efficiently under asymmetric information George Akerlof Lecture 15 begins here Chapter 12: Economics of Information A. Probabilities B. Expected value C. Risk aversion D. Value of information E. Asymmetric information F. Resolving asymmetric information with
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