lecture12 - Microeconomics I - Lecture #12, May 05, 2009 12...

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Microeconomics I - Lecture #12, May 05, 2009 12 Asymmetric Information Moral Hazard, Adverse Selection So far in our study of markets we have not examined the problems raised by differences in infor- mation: by assumption buyers and sellers were both perfectly informed about the quality of the goods being sold in the market. This assumption can be defended if it is easy to verify the quality of an item. If it is not costly to tell which goods are high-quality goods and which are low-quality goods, then the prices of the goods will simply adjust to reflect the quality differences. But if information about quality is costly to obtain, then it is no longer plausible that buyers and sellers have the same information about goods involved in transactions. There are certainly many markets in the real world in which it may be very costly or even impossible to gain accurate information about the quality of goods being sold. One example is a labor market: so far we assumed that all the workers offer a homogenous labor for sale to firms. We assumed that each worker provides the same quality of work and the same level of effort. However, in reality it can be very difficult for a firm to determine how productive workers are. When a consumer buys a used car it may be very difficult for him to determine if it is a good car or a lemon. By contrast, the seller of the used car probably has a pretty good idea of the quality of the car. We will see that this asymmetric information may cause significant problems with the efficient functioning of a market. The market for Lemons Let’s look at a model of a market where the demanders and suppliers have different information about the qualities of the goods being sold. Consider a market with 100 people who want to sell their used cars and 100 people who want to buy a used car. Everyone knows that 50 of the cars are ”plums” (high-quality cars) and 50 are ”lemons” (low-quality cars). The current owner of each car knows its quality but the prospective purchasers don’t know whether any given car is a plum or a lemon. The owner of a lemon is willing to sell it for $1000 and the owner a plum is willing to sell it for $2000. The buyers of the car are willing to pay $2400 for a plum and $1200 for a lemon. If it is easy to verify the quality of the cars there will be no problems in this market. The lemons will sell at some price between $1000 and $1200 and plums will sell at some price between $2000 and $2400. But what happens to the market if the buyers can’t observe the quality of the car? Buyers will have to guess about how much each car is worth. If each car is equally likely to be a plum as a lemon, then a buyer would be willing to pay the expected value of the car - 1 2 1200+ 1 2 2400 = $1800. The problem is as follows: Who would be willing to sell their car at that price? The owners of
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This note was uploaded on 09/21/2011 for the course ECON 1023 taught by Professor Mark during the Spring '11 term at UC Irvine.

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lecture12 - Microeconomics I - Lecture #12, May 05, 2009 12...

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