Week6 Handout (6pp)(1) - 8/24/2010 Information in...

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8/24/2010 1 Asymmetric Information Chapter 37 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? 2 Asymmetric Information in Markets A doctor knows more about medical services than does the patient. An insurance buyer knows more about his riskiness than does the insurance company. A used car’s owner knows more about it than does a potential buyer. 3 Asymmetric Information in Markets Imperfectly informed markets with one side better informed than the other are markets with asymmetric information . 4 Asymmetric Information in Markets In what ways can asymmetric information affect the functioning of a market? Applications: adverse selection, signaling, moral hazard. 5 Adverse Selection Consider a used car market. Two types of cars; “lemons” (bad) and “peaches” (good). 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. 6
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8/24/2010 2 Adverse Selection Suppose first that every buyer can tell a peach from a lemon, then lemons sell for between $1,000 and $1,200, peaches sell for between $2,000 and $2,400. Gains-to-trade are generated when buyers are well informed. 7 Adverse Selection Suppose now that no buyer can tell a peach from a lemon before buying it. What is the most a buyer will pay for any car? 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 8 Adverse Selection Suppose q = ½ Then expected value is: 1200 (1/2) + 2400(1/2) = 1800 < $2000. But at this price (1800), a peach seller would not be able to sell 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. George Akerlof (2001 Nobel Laureate) --- “Market for Lemons” 9 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. 10 Adverse Selection How many lemons can be in the market without crowding out the peaches? Buyers need to be willing to pay at least 2000 for a “peach” 11 Adverse Selection Buyers will pay $2000 for a car only if So if over one-third of all cars are lemons, then only lemons are traded. . 3 2 2000 $ 2400 $ ) 1 ( 1200 $ q q q EV 12
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8/24/2010 3 Adverse Selection with Quality Choice Buyers value high-quality umbrella at $14 and a low-quality umbrella at $8. Before buying, no buyer can tell quality.
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This note was uploaded on 02/29/2012 for the course ECON 2101 taught by Professor Unknown during the One '11 term at University of New South Wales.

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Week6 Handout (6pp)(1) - 8/24/2010 Information in...

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