7 Markets with Asymmetric Information

Question 1

Asymmetric information | Definition

Answer 1

Situation in which a buyer and a seller possess different information about a transaction.

Question 2

As consumers begin to realize that most cars sold (about three-fourths of the total) are low quality,
their perceived demand…

Answer 2

… shifts until only low-quality cars are sold.

Question 3

Whats the lemons problem?

Answer 3

With asymmetric information, low-quality goods can drive high-quality goods out of the market.

Sellers habe better information about product quality than buyers.

Question 4

What are the two possible equilibria in these markets?

Answer 4

1. all goods sell at the average price (if seller value good at v= 5000 and buyers consider EV= 6000, all goods are sold at 6000)
2. only goods sell at the price equal to the value that buyers place on it (if sellers value goods at v= 7000, they will not sell them at 6000. buyers realize good cannot be found for less than 7000)

Question 5

In which way is market failure a problem here?

Answer 5

because consumers cannot determine the quality of a used good and thus the price for it falls, and high quality goods are driven out of the market

Question 6

Adverse selection | Definition

Answer 6

Form of market failure resulting when products of different qualities are sold at a single price because
of asymmetric information, so that too much of the low-quality product and too little of the highquality product are sold.

Question 7

What are ways to solve adverse selection?

1.
2.
3.

Answer 7

1. Restricting Opportunistic Behavior
   = to restrict the ability of the informed party to take advantage of hidden information.
2. equalizing information; i.e. provide information to al parties (screening; signaling; third party information)
3. pool risks: e.g. providing insurance for ALL people over 65 (mandatory programm); low cost participants are subsidizing those with high costs

Question 8

What is Market Signaling?

Answer 8

Process by which sellers send signals to buyers conveying information about product quality.

e.g. dressing well for a job interview indicates things about people, but its a weak signal because it doesnt show how productive people are

Question 9

How can firms convince consumers that their product is high quality?

Answer 9

Guarantees and warranties effectively signal product quality because an extensive warranty is more
costly for the producer of a low-quality item than for the producer of a high-quality item.

Question 10

Moral Hazard | Definition

Answer 10

When a party whose actions are unobserved can affect the probability or magnitude of a payment
associated with an event.

eg The possibility that an individual’s behavior may change because she has insurance is an example of a
problem known as moral hazard.

Question 11

Whats job shirking?

Answer 11

workers performing below their capabilities when employers cannot monitor their behavior

Question 12

What are examples to the managers ability to deviate from the objectives of owners?

1.
2.
3.

Answer 12

1) First, stockholders can complain loudly when they feel that managers are behaving improperly.
2) Second, a vigorous market for corporate control can develop unless managers pursue the goal of
profit maximization.
3) Third, there can be a highly developed market for managers.

Question 13

What is the principal agent problem?

And whats an agency relationship?

Answer 13

Problem arising when agents (e.g., a firm’s managers, who actually have to achieve principals objective) pursue their own goals rather than the goals of
principals (e.g., the firm’s owners).

An agency relationship exists whenever there is an arrangement in which one person’s welfare
depends on what another person does.

Question 14

What is an example to reduce moral hazard in agency relationships?

Answer 14

Reducing Moral Hazard using Efficient Contracts: The principal and agent can agree to an efficient
contract, an agreement in which neither party can be made better off without harming the other.

Question 15

Adverse Selection vs Moral Hazard | Comparison

1. Piece of information that is subject to the asymmetry
2. Example
3. timing of the information asymmetry
4. How to mitigate the problem?

Answer 15

1. AS: a hidden, unknown characteistic | MH: occurs due to a hidden action
2. AS: risk of disease; quality of a product | MH: insurance markets
3. asymmetry exists before a transaction occurs | occurs after a transaction
4. screening, signaling, third-party information | contractual arrangements, monitoring, penalty

Question 16

How can a credit card company or bank distinguish high-quality borrowers (who pay their debts)
from low-quality borrowers (who don’t)?

1.
2.

Answer 16

• Clearly, borrowers have better information—i.e., they know more about whether they will pay than the lender does.
• Again, the lemons problem arises. Low-quality borrowers are more likely than high-quality borrowers to want credit, which forces the interest rate up, which increases the number of lowquality borrowers, which forces the interest rate up further, and so on.

Question 17

Asymmetric information implies unequal access to information by either buyers or sellers, a problem
that leads to inefficient markets or market collapse. Encouraging the gathering and publishing of
information can…..

Answer 17

…. be advantageous in general because it helps consumers make better decisions and
promotes honesty on the part of sellers.

Question 18

“The government should impose quality standards—e.g., firms should not be allowed to sell lowquality items.”

Is this a good idea?

1.
2.
3.
4.

Answer 18

• bad idea
• some people prefer low-quality goods if they are sufficiently inexpensive.
• Banning low-quality goods would reduce consumers’ choices and reduce utility
• after imposing quality standards, the government would have to monitor the quality of all items sold, and
  this would be very costly

Question 19

“The government should require all firms to offer extensive warranties”

Is this a good idea?

1.
2.

Answer 19

• no
• it would drive most low quality products out of the market, because it would be too costly for low-quality producers to service such warranties
• Such a requirement would negate the market signaling value of warranties offered by producers of high-quality goods. Thus, to the extent that some low-quality goods were still being sold, high-quality producers would have
  a more difficult time signaling the quality of their products.

Question 20

If a principal and agent enter into a fixed-fee contract where the agent pays the principal a licensing fee, the agent…..

Answer 20

…. bears all the risk

Question 21

In a contingent contract…..

Answer 21

….the payoffs are dependent upon another variable, such as revenue or profit.
-> In a contingent contract, the terms of the contract specify that the payoffs (such as payments or rewards) depend on the achievement of certain outcomes or the performance of specific variables like revenue or profit. This aligns the interests of the parties involved with the success of the underlying metrics.

(+ the risk neutral party does not bear the risk; monitoring is possible)

Question 22

Adverse Selection and Moral Hazard | How can we minimize these problems?

Answer 22

Adverse Selection
- screening
- signaling
- third party information

Moral Hazard
- contracual arrangements
- monitoring & penalty

Question 23

If a principal and agent enter into a fixed-fee contract where the agent pays the principal a licensing
fee, the agent….

Answer 23

…. bears all the risk

Question 24

In a contingent conrac, the payoffs….

Answer 24

…. are dependent upon another variable, such as revenue or profit.