Lesson 3.3 Flashcards
how has internet commerce affected monopolies?
Monopolies tend to break down as consumers can search and compare across many sellers
what does a lemons market arise from?
info differences between buyers and sellers/asymmetric info
is lemons market a market failure?
yes
what does lemon mean?
Lemon is used to refer to a used car that turns out to have a lot of problems not apparent at the time of purchase
what does a gem mean?
Used cars with no hidden defects
how many lemons are in used car market and why in 2 words
A disproportionate number of lemons turn up in the used car market due to info asymmetry
explain why are there a lot of lemons in used care market?
Since only sellers know true value of care they are selling, buyers will not pay more than average, this drives sellers of quality used cars/gems out of the market and drives sellers of lemons into the market because they will be happy to receive an average price
what happens in insurance with perfect info?
If insurer could distinguish between high risk and low risk groups, managers could charge competitive premiums and each group would buy insurance
what is competitive premium for each group?
expected losses
perfect info insurance - utility with insurance
initial wealth - premium
perfect info insurance - utility no insurance
probability(wealth if loss) + probability (wealth if no loss)
perfect info insurance - who will buy insurance
High risk drivers and low risk drivers will choose to buy insurance since they have higher utility with insurance
asymmetric info insurance - what do we assume about managers
Assume insurers are unable to distinguish between high and low risk drivers
asymmetric info insurance - what happens if there is equal number of low and high risk drivers
insurer can break even by charging the average premium
asymmetric info insurance - who will buy insurance
high risk drivers will buy insurance but low risk drivers will not because expected utility is higher without insurance
asymmetric info insurance - what kind of market is this
perfect lemons market
asymmetric info insurance - explain adverse selection
There is an adverse selection of drivers who choose to purchase insurance
asymmetric info insurance - who suffers
The people who suffer are the low risk drivers who are priced out of the market and insurance company because they are only insuring high risk drivers
2 ways managers can restore asymmetric info for insurance
1) increasing info about individual drivers
2) using strategic design in offering insurance choices to drivers
what does increasing info about individual drivers strategy rely on?
Relies on insurance market being highly competitive
explain increasing info about individual drivers strategy
possessing information about the expected loss from individual drivers is valuable since it will allow insurers to tailor a premium that will appeal to low risk drivers while continuing to charge high risk drivers a higher premium that reflects the differences in their expected losses. Insurers will compete with rival firms to get better information since this will mean higher profits if they can insure more drivers by attracting the low risk drivers who would otherwise opt out of buying insurance if they faced the same premium as the high risk drivers.
what does using strategic design in offering insurance choices to drivers strategy induce?
Induces policyholder to reveal info about themselves
explain defined contribution plan
employer or employee makes explicit contributions to pension plans. There is no guarantee of money in retirement
explain annuity
converts principal into constant stream of income for the rest of life
annuity market w perfect info - what does perfect info mean
health status of each individual is known both to that person and to annuity firm
annuity market w perfect info - explain what happens here
Each person receives annuity based on own health status and no one subsidizes anyone else
annuity market w perfect info - how do we calculate annuity
Divide principal by life expectancy to get annuity payments
annuity market w asymmetric info - what does asymmetric info mean
person knows health status but annuity firm does not
annuity market w asymmetric info - what happens if person lives long time
annuity firm loses money
annuity market w asymmetric info - what happens if person lives short period
annuity firm gains money
annuity market w asymmetric info - what happens if person lives for what is expected
annuity firm breaks even
annuity market w asymmetric info - what will firm do
Firm will want to break even - they find average life expectancy and base annuity base off of that and a set amount of principal. If every person bought this annuity, the firm would break-even
annuity market w asymmetric info - will poor health people buy annuity
Those in poor health will be unlikely to buy the annuity because they could just withdraw more money directly
annuity market w asymmetric info - will avg health people buy annuity
Those in average health will be indifferent, it might reduce some uncertainty
annuity market w asymmetric info - who will buy annuity
Only those in average or better health will buy the annuity
annuity market w asymmetric info - if only avg or better health people buy, what happens?
In this scenario - the firm will lose money as only those in average or better health will buy annuity. Adverse selection will cause this market to break down
evidence of adverse selection in annuity market
If average life expectancy of annuitants is greater than for the population, managers will find that annuitants live longer on average so there is adverse selection as we would expect those in good health to buy annuities
what would we expect if there was adverse selection in life insurance market
If there was adverse selection, we would expect healthier people would be less inclined to buy insurance and mortality rates for insured population would be higher than average
what actually happens in life insurance market
mortality rates are lower among those who have life insurance. This establishes that managers have been effective in establishing health status of policy holders and offering insurance to those in good health. There is no adverse selection here.
explain adverse selection in insurance
those who are in bad health are more likely to buy life insurance
how can a manager not obtain credible info
A manager cannot obtain credible info just buy asking, you will lie
what does insurer know?
1) some drivers are high risk and some are low risk
2) drivers know whether they are good or bad drivers
how should managers design policies
Managers should design policies so good drivers choose one policy and bad drivers choose another
policy A - full insurance
high premium designed to be bought by high risk drivers and offers full insurance
define full insurance
every loss is paid in full
policy B - deductible
low premium but big deductible (for good drivers)
define deductible
when insurer does not pay the full loss but pays loss minus some fixed amount
policy C - flat premium
High premium that is constant from year to year (designed to appeal to high-risk drivers)
policy D - experience related premium
high premium, higher than 3, if there are no claims, premium falls to level below 3. If there are claims, premium stays at high level higher than 3 (good drivers)
what policy do policyholders choose?
one that maximizes expected utility
define self selection menu
when buyers act in their own self-interest and use their private info about their loss probabilities to select policies
which policy would survive if there was adverse selection
only policy 1 would survive
define separating equilibrium
this solution to adverse selection induces policyholders to select their respective risk types
info asymmetry in job market
There is info asymmetry before candidate and interviewer
job market - what do managers know
Managers know that on average people with good job skills have an easier time overcoming academic hurdles
job market - direct cost of education
Direct costs of education mount as courses are repeated for those with low quality job skills
job market - how does adverse selection arises
If employers offered low entry wages to all new employees, only the lower quality applicants will be in the hiring pool
job market - how to prevent adverse selection
Managers may give people who have completed at least x courses a higher salary
job market - what do universities do
If a university wishes to signal to the market that its graduates are of high quality it must set standards sufficiently high to discourage low skilled people
define experienced goods
products whose quality cannot be determined until they are consumed
3 examples of experienced goods
car, appliances, electronics
product market - what is there incentive for low quality producers to do?
There is incentive for low quality producers to advertise products as high quality
product market - what will consumers not pay
Consumers will not pay high quality price if they do not know quality until after
product market - what do managers do
Managers take actions to create separating equilibrium so consumers can accurately determine product quality. They do this by offering product warranties.
product market - how do high quality producers beat low quality producers
High quality producer can afford to out-warranty the low-quality producer
product market - explain how this is similar to auctions
the person who values the item the most just needs to outbid the person who values the item the second most
how does adverse selection arise in product market
sellers know quality of good but consumers don’t
explain adverse selection
lack of equal info among parties before transaction takes place
explain moral hazard
problem of hidden action resulting from adverse selection
what do adverse selection and moral hazard both do?
Both adverse selection and moral hazard can lead to market failures
what price will buyers pay in lemons market?
since buyers know there will only be lemons, they will not pay avg value price but the price of the lemons
how to calculate optimal premium for auto insurance
1) expected claims/groups = premium if all types buy policy
2) see who would buy insurance and change premium as you go down
3) when you get left with who buys,
4) certainty equivalent = no insurance expected utility = Wealth function and find wealth
5) value of car - certainty equivalent = premium group would be willing to pay
in an actively competitive market, where is adverse selection reduced to?
to the cost of info
what are premiums in perfect info?
expected loss
how to determine length of warranty such that profit per house is larger than if they offered no warranty?
profit with no warranty = profit with warranty
warranty cost of high quality good vs low quality good
warranty cost is larger for low quality good
consumer reservation price for high quality good vs low quality good
higher for high quality good
moral hazard - would entrpreneur using debt financing prefer risky or safe project?
risky - they can leave debt unpaid if things go bad
