Introduction and Adverse Selection

Question 1

when does adverse selection occur *

Answer 1

when some agents have private information about a characteristic that is relevant to the transaction

Question 2

example of adverse selection

Answer 2

unobserved quality of second hand good,
consumers’ willingness to pay,
health status

Question 3

when does moral hazard occur

Answer 3

when one individual, the agent, takes an action that is not observable by another individual, the principal

Question 4

example of moral hazard

Answer 4

worker’s effort may not be perfectly observable by his employer,
unemployed worker’s search effort may not be observed by unemployment agencies

Question 5

what does Rg and Rl stand for for the lemons

Answer 5

Rg is reservation value for sellers of good cars,

Rl is reservation value for sellers of lemons

Question 6

what is Ug and Ul for the lemons

Answer 6

Ug utility if agent buys a good car,

Ul utility if agent buys a lemon

Question 7

what happens when the proportion of lemons is too large

Answer 7

they drive the good cars out of the market and only lemons are sold so the price is Ul

Question 8

explain how no cars could be sold if the proportion of lemons is too large

Answer 8

lemons obtain same price as good cars,
buyers will not pay too high of a price if there is a risk that the car is a lemon,
sellers of good cars withdraw product because not likely to get enough money
buyer knows there are no more good cars on the market

Question 9

with perfect information what is the equilibrium price for a multiple quality level car game

Answer 9

with perfect information all cars are sold (at price U1 for the lowest quality cars etc)

Question 10

with asymmetric information what is the equilibrium price for the multiple car game

Answer 10

there is a single price P

Question 11

with asymmetric information what does demand for cars depend on

Answer 11

with asymmetric information, demand for cars depends on expected quality U

Question 12

what is the equilibrium in the multiple car game

Answer 12

only type 1 cars are on the market and are sold at price U1 (this exceeds sellers’ reservation value),
the worst quality cars drive all the other cars out of the market

Question 13

when does adverse selection occur / what is it *

Answer 13

when one (or several) individuals on either side of the market has an informational advantage

Question 14

what can adverse selection lead to *

Answer 14

can lead to inefficient equilibria or even to a shut-down of the market

Question 15

how can we solve the inefficiencies caused by adverse selection due to asymmetric information *

Answer 15

information has to be passed on to uninformed individuals,
signalling (informed individuals send a signal about the hidden characteristic to the uninformed agents),
screening

Question 16

what is signalling *

Answer 16

when an informed agent send a signal about the hidden characteristic to the uninformed agent

Question 17

what is screening *

Answer 17

the uninformed agent forces informed individuals to reveal information

Question 18

when do problems of asymmetric information arise

Answer 18

these problems arise in markets when some agents have more information than others

Question 19

what can asymmetric information create

Answer 19

distortions that mean the competitive equilibrium may not be pareto efficient and the market may not even reach an equilibrium

Question 20

in adverse selection what can informed individuals do

Answer 20

informed individuals may send information to the uninformed party, signalling

Question 21

what does the principal do *

Answer 21

the principal designs contracts in order to provide the agent with incentives to take a given action, for example, exert a given level of effort

Question 22

under perfect information what is the equilibrium of the market for cars with lemons *

Answer 22

buyers are willing to pay up to Ug for good cars and up to Ul for lemons,
sellers of good cars gain nothing by setting price lower than Ug since there are more buyers (so will always be able to find someone willing to pay Ug),
sellers of good cars post price Ug and sellers of lemons post price Ul (these prices are above their relative reservation values),
all cars are sold

Question 23

features of perfect information equilibrium in simplest model for car market *

Answer 23

price of good cars Ug, price of lemons Ul,
all cars are sold,
equilibrium is pareto-efficient,
sellers capture all the surplus,
this relies on assumption that the quality of cars is public information

Question 24

under asymmetric information what is the utility for the buyers now they do not know the quality of the car *

Answer 24

U = (1-θ)Ug + θUl,

Question 25

what price do sellers now charge under asymmetric information *

Answer 25

buyers utility U=(1-θ)Ug+θUl for all cars,
sellers can charge up to U for their car, regardless of its quality, they gain nothing by selling car at a price lower than U

Question 26

feature of sellers of lemons in asymmetric market if they sell car for U (U = (1-θ)Ug + θUl)

Answer 26

at this price sellers of lemons are sure to make a positive profit, and they are better off than in the full information equilibrium since: U > Ul

Question 27

under asymmetric information sellers of good cars are willing to sell at the price U only if…

Answer 27

Rg < U,
Rg < (1-θ)Ug + θUl,
θ < (Ug-Rg) / (Ug-Ul) = θhat

Question 28

what is the equilibrium if θ less than theta hat

Answer 28

all cars sold at single price U,
sellers of lemons sell their car for more than it is worth to buyers,
sellers of good cars could have sold for more under perfect info but U still exceeds Rl

Question 29

what is the equilibrium if θ>θhat,

high proportion of lemons *

Answer 29

proportion of lemons so large that expected quality U is below reservation value of sellers of good cars,
since good cars would sell at a loss they are taken off the market,
proportion of lemons in market becomes 1 so only lemons sold and buyers know this so price is Ul,
not pareto efficient

Question 30

what happens when the proportion of lemons is too high

Answer 30

lemons drive the good cars out of the market

Question 31

with asymmetric information what does demand for cars depend on

Answer 31

expected quality U