Notes Ch 17 - Markets with Asymmetric Information Pindyck...

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Markets with Asymmetric Information Pindyck and Rubinfeld Chapter 17 - We can see what happens when some parties know more than others – asymmetric information -Frequently a seller or producer knows more about the quality of the product than the buyer does -A buyer of insurance knows more about the likelihood of making a claim than the seller (the insurance company) -Managers know more about costs, competitive position and investment opportunities than firm owners Sometimes people find it to be in their best interest NOT to share information. Quality Uncertainty and the Market for Lemons (Hidden Information) Market Signaling (Hidden Information) Moral Hazard (Hidden Action) The Principal-Agent Problem (Hidden Action) Managerial Incentives in an Integrated Firm (Hidden Action) Asymmetric Information in Labor Markets: Efficiency Wage Theory (Dynamic Hidden Action)
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Quality Uncertainty and the Market for Lemons (Akerlof) Problem of ADVERSE SELECTION Two kinds of used cars – high quality and low quality (lemons) First, let’s consider what happens if there’s PERFECT/COMPLETE INFORMATION (i.e. no asymmetry): If there’s no asymmetry of information, buyers and sellers can distinguish between the high and low quality cars Two markets – High quality used cars and low quality used cars High quality market o S H is supply and D H is demand for high quality Low quality market o S L is supply and D L is demand for low quality S H is higher than S L because owners of high quality cars need more money to sell them D H is higher than D L because people are willing to pay more for higher quality P H P L Q H Q L S H S L D H D L 5,000 50,000 50,000 10,000 D L Market price for high quality cars is $10,000. Market price for low quality cars is $5000. 50,000 of each type are sold.
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Now, let’s see when there’s ASYMMETRIC INFORMATION: Sellers know more about the quality of the used car than the buyer Buyers know that there are high and low quality cars, but can’t tell the difference by looking at them. Assume buyers can only discover quality after purchasing car. We also assume buyers know the distribution of high and low quality cars on the market. (On the last slide, 50,000 of each type were sold.) If there are equal numbers of high and low quality cars being offered for sale, then (initially) buyers may think the odds are 50/50 that the car is high quality. The expected quality is “medium”: 0.5(V L ) + 0.5(V H ) where V i is the value to the buyer of a car of quality i , for i = L, H.
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Buyers will view all cars as medium quality with demand D M However, fewer high quality cars (25,000) and more low quality cars (75,000) will now be sold. Now, there are three times as many low quality as high quality cars.
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This note was uploaded on 04/19/2011 for the course ECON 101 taught by Professor Gul during the Fall '11 term at Lahore School of Economics.

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Notes Ch 17 - Markets with Asymmetric Information Pindyck...

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