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QUESTIONS FOR REVIEW
1. Why can asymmetric information between buyers and sellers lead to market failure when
a market is otherwise perfectly competitive?
Asymmetric information leads to market failure because the transaction price does not reflect
either the marginal benefit to the buyer or the marginal cost of the seller. The competitive market
fails to achieve an output with a price equal to marginal cost. In some extreme cases, if there is no
mechanism to reduce the problem of asymmetric information, the market collapses completely.
For example, in the used car case buyers do not know for sure if they will be getting a high or low
quality car, and as a result they tend to be willing to pay less for a car than high quality owners
are willing to accept. As a result, not many high quality cars will be offered for sale and this leads
to market failure.
2. If the used car market is a “lemons” market, how would you expect the repair record of
used cars that are sold to compare with the repair record of those not sold?
In the market for used cars, the seller has a better idea of the quality of the used car than does the
buyer. The repair record of a used car is one indicator of its quality. One would expect that, at the
margin, cars with good repair records would be kept while cars with poor repair records would be
sold. Thus, one would expect the repair records of used cars that are sold to be worse than those
of used cars not sold, i.e., kept by their owners.
3. Explain the difference between adverse selection and moral hazard in insurance markets.
Can one exist without the other?
In insurance markets, both adverse selection and moral hazard exist. Adverse selection refers to
the self-selection of individuals who purchase insurance policies. That is, people who are less
risky than average will, at the margin, choose not to insure, while people more risky than the
population as a whole will choose to insure. As a result, the insurance company is left with a
riskier pool of policy holders. The problem of moral hazard occurs after the insurance is
purchased. Once insurance is purchased, less risky individuals might engage in behavior
characteristic of more risky individuals. If policy holders are fully insured, they have little
incentive to avoid risky situations.
An insurance firm may reduce adverse selection, without reducing moral hazard, and vice versa.
Conducting research to determine the riskiness of a
customer helps insurance companies
reduce adverse selection. Furthermore, insurance companies reevaluate the premium (sometimes
canceling the policy) when claims are made against the policy, thereby reducing moral hazard.
Co-payments also reduce moral hazard by creating a disincentive for policyholders to engage in