Mod 5 - Topic 1 - Risk analysis, uncertainty and incentives Flashcards
What is asymmetric information?
A situation in which a buyer and a seller possess different information about a transaction.
Explain the asymmetric information problem with used cars and how this impacts the market?
Buyers don’t know if the car is good (a cherry) or bad (a lemon), if good cars are worth $10k and bad $4k. Price is therefore usually closer to $4k due to uncertainty. As a result the quantity of high quality products offered is less and the price decreases further.
What is the lemons problem?
With asymmetric information low-quality goods can drive high-quality goods out of the market.
What is adverse selection?
Form of market failure resulting from when products of different qualities are sold at a single price because of asymmetric information so that too much of the low-quality product are sold and too little of the high product.
Where else is asymmetric information present?
- Insurance - people who seek insurance know more about their health and likely to be less healthy
- Credit - use of credit history to determine high from low quality.
- Retail - does a firm allow repairs or returns
- Collectables - are they real or fake
- Trades - quality of the work provided
- Restaurants - health and freshness
What is market signalling?
A process by which sellers send signals to buyers conveying information about product quality.
What is a strong market signal?
One which is easier for high-productivity people to give and receive than for low-productivity.
What are two examples of market signalling?
- Use of guarantees and warranties on products
* Education for employees
What is moral hazard?
When a party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event. It alters the ability of markets to allocate resources efficiently. eg. public transport is higher cost because some users avoid paying.
What is the principal agent problem?
Problem arising when agents (firm’s managers) pursue their own goals rather than the goals of principals (firm’s owners)
What is an agent?
The individual employed by a principal to achieve the principal’s objective.
What is a principal?
Individual who employs one or more agents to achieve an objective.
What is horizontal integration?
Organisational form in which several plants produce the same or related products for a firm.
What is vertical integration?
Organisational form in which a firm contains several divisions, with some producing parts and components that others use to produce final products
In an integrated firm division managers are likely to have better information about operating cost and production than central management has. What two problems does this asymmetric information cause?
1) How can central management elicit accurate information?
2) What rewards and incentives should management use to encourage divisional managers to work as efficiently as possible.
