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Unformatted text preview: Chapter 22 Asymmetric Information in Competitive Markets In our treatment of externalities in Chapter 21, we introduced into our model for the first time an economic force (other than government-induced price distortions) that causes a competitive market to allocate scarce goods inefficiently in the absence of some other market or non-market institution. We furthermore illustrated that the problems raised by externalities are problems related to the non-existence of some market, necessitating either the establishment of a new market or the fine- tuning of market forces by some non-market institution. In this chapter, we will see another example of an economic force that can result in the non-existence of certain markets and in an inefficient allocation of scarce resources in existing markets. This economic force arises from certain types of information being distributed asymmetrically across potential market participants and, as we will see, it relates closely to a particular type of externality that is generated in the process. Information is, of course, always different for buyers and sellers with buyers knowing about the tastes and economic circumstances that underlie their demand for a good and sellers knowing the costs of production that underly their supply decisions. One of the great advantages of markets is that, through the formation of market prices, such information is utilized in an efficient manner as the price sends just the right signal to buyers and sellers about how scarce goods should be allocated in the market. Information asymmetries that cause externality problems in markets, however, are different than simply different sets of knowledge about our own individual tastes and costs. They involve hidden information that impacts others adversely because the information can be used to take advantage of the person on the other side of the market. We will then say that information asymmetries occur whenever buyers and sellers have different information regarding the nature of the product (or service) that is being traded or the true costs of providing that product (or service). A common example of this occurs in insurance markets. Suppose, for instance, I approach a health insurance company about my interest in purchasing health insurance. I have inherently more information than the insurance company. In particular, I know more about my own health status and thus the likelihood that I will need health care, than the insurance company, and I know more about how my lifestyle might change if I know that I am insured. This is information the insurance company would very much like to have in order to ascertain the likely cost of providing insurance to me. The worse my health is and the more likely I am to engage in risky behavior if I am insured, the more costly it is likely to be for the insurance 650 Chapter 22. Asymmetric Information in Competitive Markets company to provide health insurance to me. And I have every incentive to hide bad health or acompany to provide health insurance to me....
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- Fall '07