Class 16s

Class 16s - Department of Economics LeBow College of...

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Department of Economics Fall 2009 LeBow College of Business Economics 301 Drexel University Professor Stehr Class 16 1) Asymmetric information 2) Moral hazard 3) Financial crisis Asymmetric information—situation in which a buyer and seller possess different information about a transaction or good Consider the market for used cars Suppose the used car market has 10,001 cars and that their true values are 0, 1, 2, 3, 4, 5… 10,000 If buyers and sellers both know the true value of the car, each car will be sold for its true value. More realistically, if sellers know the true value of their cars, but buyers are unaware, then a buyer will only be willing to pay the average value of a car, or $5,000. Sellers with a car of value greater than $5,000 will refuse to sell their car since this price is lower than the true value. But now, with the higher value cars out of the market, buyers will eventually realize that the average value of a car has fallen to $2,500, so they will only be willing to pay this price. This adverse selection continues and in the extreme, the market for used cars will collapse. This is a market failure because those willing to pay a price equal to the value of a car can’t get one. Adverse selection—a process arising from asymmetric information where those remaining in the market have characteristics that systematically differ from the population average Adverse selection due to asymmetric information arises in markets for insurance and credit. Solutions: Health insurance Risk pools—employers purchase insurance for large groups of employees at once reducing or eliminating the role of adverse selection 1
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Auto insurance Credit markets In other markets such as retail, services, restaurants, reputation can signal quality as can guarantees. Moral hazard in insurance—situation in which individuals increase the probability of an event after purchasing insurance against an event because they are no longer fully liable for the costs associated with the event Example: I drive more recklessly once I buy auto insurance, I fail to replace the batteries in my fire alarms once I buy home insurance, I make more doctor visits once I have health insurance. The Financial Crisis: Market for mortgages Mortgage—loan secured by real estate. If the borrower defaults on the loan, the lender has the right to seize the property and sell it to pay off the loan Traditionally, a lender required the borrower to pay 20% of the value of the property as a down payment. That way, the lender could recover his investment even if the borrower defaulted and the value of the property fell by up to 20% Regulations vary by state, but mortgages are limited liability loans, where the lender’s ability to recover the loan is limited to the property bought with the loan and possibly some other assets. A borrower can certainly avoid having his future wages garnished by going through bankruptcy.
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Class 16s - Department of Economics LeBow College of...

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