asymmetric information

Question 1

what is adverse selection

Answer 1

when sellers have info buyers do not have or vice versa about some aspect of product quality.

Question 2

Used car market

Answer 2

Plums and lemons
Sellers want 2000 for plums 1000 lemons
Buyers willing to pay 2400 for plums, 1200 for lemons.
They don’t know which is which. 50-50 chance.
Expected value of a car to a buyer = 1800
1800 < 2000 therefore no plums sold.
Buyers are rational, they know only lemons are available.
Thus aren’t willing to pay more than > £1200.
Inefficient outcome at equilibrium with only lemons sold… marker failure

Question 3

why is there market failure in plum lemon market

Answer 3

Many mutually advantageous trades not made

Question 4

Pen example

Answer 4

High quality (g) or low quality (1-g) .
Value of high quality = £4
Value of low quality = £2
Expected value of pen = 2g + 2
cost of pen = £3
Competitive market therefore p = mc = 3
g = 0 , only low quality pens, no pens sold since 3>2
g =1, all high quality, all pens sold, consumer surplus = 1
g must be bigger than or equal to 0.5 in order for buyer to want to buy the pen
Producer makes 0 profit at all times, consumer surplus increases as g increases.

Question 5

pen example 2

Answer 5

High quality pens cost £3 to make
low = £2,50
sellers all make low since cheaper.
g = 0, 2.50>2 therefore no pens sold

Question 6

Motor vehicle insurance

…. health insurance?

Answer 6

Uses prob of entire population getting into an accident.
Seller doesn’t know buyers…
Only those more likely to get in accidents get insurance.
Prob of accident of those buying insurance policies > population
Firm does bankrupt.

Question 7

moral hazard

Answer 7

hidden action problems.
Not taking care since they don’t experience the consequences.
If amount of care is observable/costlessly verifiable… no problem.
No insurance or very high premium and very low imbursement, insurance buyer likely to take more care

Question 8

what does adverse selection cause

Answer 8

market failure

Question 9

asymmetric information examples

Answer 9

Implementing a pigouvian tax to achieve efficiency may not work since a lot of the information surrounding a company is private.
Reservation price is private information…