Lecture 14

Lecture 14 - strategic interactions, a party often knows...

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strategic interactions, a party often knows something that is relevant to the problem but is not known by some other party. In that case, we say that players have asymmetric information. When you are interacting with parties that have private information, if you don’t take the necessary precautions, you will likely to end up in a situation that you wouldn’t want to be in. This is because the other party will act in his self interest given his information, which will not necessarily be in your interest. This is called adverse selection. For example, the used car that you buy at a low price is likely to be a lemon with many defects, as the owner wouldn’t want to sell at such a low price if it were a good car. The candidate who accepted your low wage offer was probably desperately looking for a job and would have accepted even a lower wage. What is worse, he is desperate because he is often fired for misbehavior. The nice looking guy that you have met the other day is likely to be a lousy boyfriend whose relationships do not last long. Why else is he still single? What if he is not single? These kinds of concerns usually make people cautious and prevent trade or other joint decisions that would have been beneficial for all parties and would have been realized if there were no asymmetric information. In this lecture I present examples of adverse selection and illustrate how we compute an equilibrium. 1.1 Bargaining Consider a seller, who owns an object, and a buyer. The value of object is c [0, 1] for the seller and v [0, 1] for the buyer. Seller sets a price p, and buyer decides whether to 1 buy it. Seller knows c. Let’s first assume that the buyer does not know v; he thinks that v is uniformly distributed on [0, 1]. Clearly, buyer will by the object iff p ≤ 1/2. The seller will set p = 1/2 if c ≤ 1/2, and will set a high price if c is higher. Trade is realized
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Lecture 14 - strategic interactions, a party often knows...

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