lecturenotes_test4 - Policy Applications 1 Adverse...

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Policy Applications 1. Adverse Selection and Moral Hazard Asymmetric information occurs when a situation when one side of the market (buyers or sellers) has better information about the product than the other. When Sellers Have More Knowledge Than Buyers Ex. The used car market Economists make the assumption that the typical buyer is willing to pay some amount of money for a “lemon” (vehicles with relatively high repair costs) and a higher amount for “plums” (high quality vehicles). The market outcome is based primarily on consumer expectations of the composition of the market (i.e. what share of used cars are lemons). But, sellers typically have more information on the vehicles on the market (e.g. know what is wrong with the vehicle, know the level of maintenance of the vehicle, etc.). So, buyers are basing their information set only on what they see on the road . If a buyer believes that 50% of the vehicles on the road are lemons, then they may assume that the same percentage of vehicles is lemons on the lots. It is reasonable for consumers to internally calculate an expected WTP for a certain probability of getting a plum or a lemon (p. 173). If I am WTP $2000 for a lemon (because I know I will have to service this lower-quality vehicle more often or because it gets low mpg) and I am WTP $4000 for a plum, then my expected value for a 50-50 chance of getting a lemon or a plum is $3000 [(4000+2000)/2]. Therefore, there will be so many vehicles supplied to the market at that price. [Remember that sellers will only supply those used vehicles to the market if their WTA = the WTP by buyers.] So, we get a situation where a certain number of lemons and plums are supplied to the used vehicle market. Then, over time, as future buyers realize the lower quality of used vehicles, the transactions price will decrease. Beyond the point where at least one plum is supplied to the market ($2500 in the example on p. 173), all of the used vehicles will be lemons. This is because of consumers’ pessimistic expectations of the quality of these used vehicles! Good consumer expectations are associated with higher WTP; pessimistic expectations are associated with lower WTP. This illustrates the adverse selection problem , which is a situation in which the uninformed side of the market must choose from an undesirable or adverse selection of goods. Also note that the used vehicle market will be in equilibrium only when the consumers’ expectation of getting a lemon equals the percentage of used vehicles that are lemons. Otherwise, the used vehicle market is in disequilibrium, meaning that plums exist in a market with pessimistic expectations. Overall, asymmetric information generates a downward spiral of price and quantity: a. the presence of low-quality goods on the market pulls down the price consumers are WTP. b.
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This note was uploaded on 11/16/2011 for the course ECON 2106 taught by Professor Staff during the Fall '08 term at Valdosta State University .

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lecturenotes_test4 - Policy Applications 1 Adverse...

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