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SGABCh22 - CHAPTER 22 Asymmetric Information in Competitive...

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C H A P T E R 22 Asymmetric Information in Competitive Markets This is our final chapter dealing with competitive markets — and our final inves- tigation of violations of the first welfare theorem within competitive settings. The issue we are concerned about in this chapter is hidden information; i.e. informa- tion that is relevant to a transaction but which only one party to the transaction has. Such hidden information opens the possibility of one side of the market “exploit- ing” the other — such as the owner of a used car misinforming the potential buyer of its quality. It also opens the possibility of high quality producers not being able to sell their goods because low quality producers are successfully imitating them, with consumers unable to tell the difference when purchasing the product. One market in which we know the issue of hidden, or asymmetric, information to be important is the insurance market where those seeking insurance might have in- formation about their circumstances that insurance companies cannot see. And it is within the context of insurance markets that many of the ideas related to adverse selection are treated in much of this chapter. Chapter Highlights The main points of the chapter are: 1. The adverse selection problem (in output markets) arises when a full market cannot be sustained in equilibrium because of the negative externality im- posed by high cost consumers on low cost consumers. Put differently, when firms cannot tell high cost from low cost consumers (in areas like health in- surance), they may be unable to price their product so that low cost con- sumers are willing to buy it — which may also imply that the price would rise to a point where even high cost consumers will not buy it. 2. If less informed parties (like insurance companies) know that certain iden- tifiable groups are more likely to contain high cost consumers, they will use
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Asymmetric Information in Competitive Markets 524 group characteristics to statistically discriminate against particular groups (even if they have no prejudice against that group.) 3. Moral hazard refers to the change in behavior an individual will undertake once a contract is entered into — such as the tendency to engage in riskier behavior once health insurance is obtained. If firms cannot tell who is more and who is less likely to engage in moral hazard, this can aggravate the ad- verse selection problem. 4. Signals and screens are often used by firms, consumers and workers in or- der to overcome at least part of the adverse selection problem. Signals are used by the more informed party to “signal” information to the less informed party; screens are used by the less informed party to “screen” for information that the other party has.
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