Topic 2: Asymmetrical Information

Question 1

What is adverse selection?

Answer 1

When assymetrical information is present, such that one side of a market makes purchasing decisions in a way to exploit it.

Question 2

What does Sutterthwaite argue in his 1979 paper?

Answer 2

That under monopolistic competition, with a reputiation based good, an increased number of sellers will actually increase the average market price.

Question 3

What mechanisms does Sutterthwiate in his 1979 paper describe to explain his conclusion?

Answer 3

1. When the number of docts in an area increases, consumer information on each indervidual doctor decreases
2. As searching for a new doctor becomes more costly, consumers become more price insensitive.

Question 4

Are there any alternative explainations for the result shown in Sutterthwaite’s 1979 paper?

Answer 4

That under increased competition, doctors up there game and try and provite more quality services to maintain or increase price level

Question 5

Why does asymmetrical information drive out high quality sellers, as in Arerloff’s Lemon Market model

Answer 5

1. Buyers only know average characteristics of good quality, and so offer an average price on the market
2. It’s very possible that this average price is to low for sellers to bother selling. Thus they do not sell, and the average quality on the market decreases further.
3. As a result all high quality sellers leaving the market is a possibility
4. When quality is a distribution, not a binary high/low, this may cause a total market collapse

Question 6

Give a mathematical condition that shows when Lemon Markets will not collapse

Answer 6

Bv ( E( Sv (P) ) ) >= P

Where the buyers value of the goods being sold, a function of the expected value of the products sold, determined by the sellers as a function of the market price, is itself over or equal to the market price.

Question 7

Is there a principal-agent problem with doctors

Answer 7

Possibly, as:

• difficult for consumers to determine the medical necessity of services
• Incentive to be lazy if payed a fixed wage, not try as hard as possible ( moral hazard)

Question 8

Are there any solutions to the principle agent problem?

Answer 8

You can make payment dependant on outcome, but this introduces risk into the equation, as outcome is usually inherrently risky regardless of the agents effort.