Asymmetric Information

Question 1

What is Asymmetric information?

Answer 1

When one party in a transaction has more or better information than the other

Question 2

What are the two main types of asymmetric information?

Answer 2

Hidden characteristics and hidden actions

Adverse selection and Moral hazard caused by these

Question 3

Define adverse selction

Answer 3

A problem where the informed party self selects in a way that harms the uniformed party

Question 4

what is the market for lemons problem?

Answer 4

High quality good exit the market because buyers cant distinguish them from low quality goods leading to a market full of “lemons”

Question 5

How can signalling reduce adverse selection?

Answer 5

The informed part (e.g high ability worker) takes an action (e.g gets a degree) that reveals their type

Question 6

What is moral hazard?

Answer 6

When one party takes unobservable actions that affects outcomes - often leading them to take more risks

Question 7

What is the principal agent problem?

Answer 7

When the agents actions affect the principal but cannot be perfectly monitored

Question 8

Give 2 ways to reduce moral hazard

Answer 8

1. performance based compensation
2. reputation mechanisms

Question 9

How does moral hazard appear in product markets?

Answer 9

Firms may reduce product quality if consumers can’t observe it, especially after the purchase.

Question 10

Why do reputations matter in solving asymmetric info problems?

Answer 10

because long-term relationships and repeat purchases incentivise firms or agents to behave honestly

Question 11

How do you find EV in lemons market?

Answer 11

EV=1200(1−q)+2400q

1200 =The buyer’s max willingness to pay for a lemon
2400 = The buyer’s max willingness to pay for a peach
q = The probability (share) of peaches in the market
1-q = The probability of getting a lemon

if EV < 2000 (the peach seller’s minimum acceptable price), peaches will exit the market.