Theme 11 - Asymetric information, Adverse selection Flashcards
When does asymetric information occurs?
When a person has access to economically relevant information that is not known by all
When does adverse selection occurs?
When high-quality goods are forced out of the market and only low-quality goods are traded
Why does market failure occurs?
When mutually beneficial trades are not taking place
Ex.: Market failure occurs because there are unsold cars remaining that the seller would be willing to sell at market price and there are buyers who would be willing to buy at that price
What is signaling?
Signaling is a solution to the adverse selection problem and recover the market efficiency.
Signaling comes from the initiative of the informed individual or group (the reseller) who wishes to signal the good quality of his product.
The signal must be credible. To be credible, the individual who wishes to signal the quality of his product must use a costly instrument that would not be used by owners of low-quality goods.
What are some example of market with adverse selection?
- Car market
- Insurance markets (car, home, health, other)
- In general, customers buying insurance know better that the insurance company the risk associated with their behaviour
- The insurer doesn’t know wether the customer is a “good” or “bad” risk - Job market
- Employers may have difficulty identifying the “best candidates” - Credit market
What is screening?
A solution
Screening comes from the initiative of the uninformed party (ex.: an insurer)
Past claims, aptitude tests, medical tests, individual’s characteristics (female-male-youth) and place of residence.
Ex: education
What can government intervention do?
Ex.: make it mandatory for insurers to cover people with preexisting health conditions
What can government intervention do?
Ex.: make it mandatory for insurers to cover people with preexisting health conditions
What are the five solutions to the problem of adverse selection?
Signaling: solution used by informed agents to signal the high quality of their product by using a costly instrument
Screening: solution used by uninformed agents to screen good risks from bad risks
Regulation: solution that involves the government
Certification: solution that directly transmits information to the uninformed agent and eliminates any asymetry
Brands and reputation: solution that can credibly reveal the quality of the product
