Week 6 lec - AsymmetricInformationinMarkets

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Week 6 ECON2101 1 Chapter Thirty Seven Asymmetric Information Information in Competitive Markets 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 What about markets for medical services, or insurance, or used cars? Week 6 ECON2101 2 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. Week 6 ECON2101 3 Asymmetric Information in Markets Imperfectly informed markets with one side better informed than the other are markets with asymmetric information . Week 6 ECON2101 4 Asymmetric Information in Markets In what ways can asymmetric information affect the functioning of a market? Applications: adverse selection (this one will be considered in detail) signaling (example) moral hazard Week 6 ECON2101 5 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 buyer will pay at most $1,200. Each peach seller will accept $2,000; a buyer will pay at most $2,400. Week 6 ECON2101 6
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2 Adverse Selection If every buyer can tell a peach from a lemon, then lemons sell for between $1,000 and $1,200, peaches sell for between $2,000 and $2,400. Gains to trade are generated when buyers are well informed. Week 6 ECON2101 7 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? Week 6 ECON2101 8 Adverse Selection 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 Week 6 ECON2101 9 EV q q $1200( ) $2400 . 1 Adverse Selection Suppose q = ½ Then expected value is 1200 (1/2) + 2400(1/2) = 1800 < $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. George Akerlof (Nobel Laureate) ‐‐‐ Market for Lemons Week 6 ECON2101 10 Adverse Selection Hence “too many” lemons “crowd out” the peaches from the market. Gains to trade are reduced since no peaches are traded are traded. The presence of the lemons inflicts an external cost on buyers and peach owners. Week 6 ECON2101 11 Adverse Selection How many lemons can be in the market without crowding out the peaches? Buyers need to be willing to pay at least 2000
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This note was uploaded on 05/17/2011 for the course ECON 2103 taught by Professor No during the Fall '10 term at DeVry NJ.

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Week 6 lec - AsymmetricInformationinMarkets

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