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Ch36 - Chapter Thirty-Six Asymmetric Information...

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Chapter Thirty-Six Asymmetric Information
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Information in Competitive Markets In purely competitive markets all agents are fully informed about traded commodities and other aspects of the market. What about markets for medical services, or insurance, or used cars?
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Asymmetric Information in Markets A doctor knows more about medical services than does the buyer. An insurance buyer knows more about his riskiness than does the seller. A used car’s owner knows more about it than does a potential buyer.
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Asymmetric Information in Markets Markets with one side or the other imperfectly informed are markets with imperfect information . Imperfectly informed markets with one side better informed than the other are markets with asymmetric information .
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Asymmetric Information in Markets In what ways can asymmetric information affect the functioning of a market? Four applications will be considered: s adverse selection s signaling s moral hazard s incentives contracting.
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Adverse Selection Consider a used car market. Two types of cars; “lemons” and “peaches”. Each lemon seller will accept $1,000; a buyer will pay at most $1,200. Each peach seller will accept $2,000; a buyer will pay at most $2,400.
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Adverse Selection If every buyer can tell a peach from a lemon, then lemons sell for between $1,000 and $1,200, and peaches sell for between $2,000 and $2,400. Gains-to-trade are generated when buyers are well informed.
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Adverse Selection Suppose no buyer can tell a peach from a lemon before buying. What is the most a buyer will pay for any car?
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Adverse Selection Let q be the fraction of peaches. 1 - q is the fraction of lemons. Expected value to a buyer of any car is at most EV q q = - + $1200( ) $2400 . 1
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Adverse Selection Suppose EV > $2000. Every seller can negotiate a price between $2000 and $EV (no matter if the car is a lemon or a peach). All sellers gain from being in the market.
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Adverse Selection Suppose EV < $2000. A peach seller cannot negotiate a price above $2000 and will exit the market. So all buyers know that remaining sellers own lemons only. Buyers will pay at most $1200 and only lemons are sold.
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Adverse Selection Hence “too many” lemons “crowd out” the peaches from the market. Gains-to-trade are reduced since no peaches are traded. The presence of the lemons inflicts an external cost on buyers and peach owners.
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Adverse Selection How many lemons can be in the market without crowding out the peaches? Buyers will pay $2000 for a car only if 2000 $ 2400 $ ) 1 ( 1200 $ + - = q q EV
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Adverse Selection How many lemons can be in the market without crowding out the peaches? Buyers will pay $2000 for a car only if So if over one-third of all cars are lemons, then only lemons are traded.
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