Lec_15_econ_of_uncertainty

# Lets say the value of a good used car to you is 10000

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Let’s say the value of a good used car to you is \$10,000. But the value of a lemon to you is only \$6,000. Question: how much are you willing to pay to buy a used car? Calculations of buyer If: 90% of the used cars for sale are good (worth \$10,000) 10% are lemons (worth \$6,000) you are risk neutral then: you’d be willing to pay (0.9 x \$10,000) + (0.1 x \$6,000) = \$9,600 for a used car

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3 Calculations of seller Seller (unlike the buyer) knows whether she has a lemon Buyer offers \$9,600 If car is good, it’s worth \$10,000, seller wouldn’t want to part with it for \$9,600 If car is lemon, great idea to sell it Resulting equilibrium: only lemons are sold on the used car market Key feature that produced this phenomenon: asymmetric information Seller knows quality of car, buyer does not Markets can fail to function efficiently under asymmetric information George Akerlof Chapter 12: Economics of Information A. Probabilities B. Expected value C. Risk aversion D. Value of information E. Asymmetric information F. Resolving asymmetric information with costly-to-fake signaling Problem: potential seller of a used car needs some way to convince buyer that the car is not a lemon In game theory, we saw that the key to resolving credibility problem was some kind of commitment mechanism Under asymmetric information, the market’s solution to the problem can be costly-to-fake signaling
4 Suppose the seller of a used car issues a warranty If the car needs repair within the first year, seller

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• Spring '08
• Kim
• Economics, used car, B. Expected value, C. Risk aversion

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