9a. Introduction on Asymmetric Information Flashcards
What is “asymmetric information”?
In many markets buyers and sellers have different information, which can lead to market inefficiencies
Asymmetry in information is either due to hidden/ private characteristics or hidden/ private actions
What are the two main types of asymmetric information?
- Adverse Selection
- Moral Hazard
What is “adverse selection”?
In cases with hidden characteristics, agents can use their private information to decide whether to participate in a transaction or a market, causing adverse selection
What is “moral hazard”?
In cases with hidden actions, an agent can take an action that adversely affects another agent, causing moral hazard
What is an example of a “moral hazard”?
I have health insurance, so I don’t care about my health since the insurance will cover the costs of healthcare
What is an example of “adverse selection”?
I sell a second-hand car, but only I know how good my car is!
What are “hidden characteristics”?
One side observes something about the good in the market that is both relevant for and not observed by the other party.
Say in the used car market 50% are peaches and 50% are lemons… how much would you be willing to offer?
(A peach has a value of $8000, a lemon has a value of $0)
expected value = 0.5(8000) + 0.5(0) = $4000
However… if you offer 4000 to the seller, most likely only the seller with the lemon would sell!
-> pushing good cars (peaches) out of the market
What if a buyer is willing to pay $4000 for a lemon car, and the seller of a second-hand car is willing to sell at a minimum of $3000, what would the graph look like?
(and consumers know that the car is a lemon car!)
D* = is the demand if peaches + lemons are pooled together [ 0.5(8000) + 0.5(4000) ] = $6000
DL = $4000
If no one can tell a lemon from a good car at the time of purchase, what would the demand/ price for lemons look like?
D* = is the demand if peaches + lemons are pooled together [ 0.5(8000) + 0.5(4000) ] = $6000
So equilibrium price of $6000
What if a buyer is willing to pay $8000 for a good car, and the seller of a peach is willing to sell at a minimum of $7000, what would the graph look like?
(and consumers know that the car is a peach car!)
equilibrium at E,
price of $8000 !
Consider no one can tell a lemon from a peach. What are buyers willing to pay for any car?
D* = is the demand if peaches + lemons are pooled together [ 0.5(8000) + 0.5(4000) ] = $6000
Consider that the reservation price for the owner of a good car is $7000, say no one can tell a lemon from a peach, what happens?
if v=$7000 and p=$6000, sellers of good cars value their car more than the price that they can receive in the market = they DONT sell
-> Inefficiency: some potential trades are NOT realized…
Consider that the reservation price for the owner of a good car is $5000, say no one can tell a lemon from a peach, what happens?
DIG: light red curve, equilibrium at point F
owners of peaches would be happy to sell as they value their car at $5000 and can sell for $6000. However, owners of lemons would do the same and make a $3000 profit. Essentially, the sellers of good-quality cars are implicitly subsidizing sellers of lemons.
What could happen to the market due to asymmetric information?
Only lemons sell for a price equal to the value that buyers place on lemons. Lemons drive peaches out of the market.
No items are sold. Adverse Selection may be so large that the entire market disappears.
-> these are both inefficient because high-quality items remain in the hands of people who value them less than potential buyers do.
