WEEK 3 Adverse Selection Flashcards
Signalling, Lemons Model, University,
Explain how the LEMONS model leads to market failure
It shows how information asymmetry can lead to a reduction in overall quality and adverse selection.
The lemons model is a representation of the used car market with cheap low quality (lemons) and high quality (peaches). Sellers know more about the car and buyers cant tell if car is lemon or peaches just by looking at it so are hesitant to pay high prices for cars leading the high quality cars to exit the market as there is no demand therefore only cheap cars low quality cars in the end will remain all because of information asymmetry.
Adverse selection - define, example insurance market
When one party has more information than the other leading to a selection bias in goods or services exchanged. In insurance market, the applicant knows more about their driving risk and those with higher risk will still get insurance and the more of these high risk people the more likely premium will increase.
What is signalling and explain the ability signalling game
Signalling is a way to convey credibility and quality in order to reduce the asymmetric information gap.
The game is where there is two types of people Low quality and High quality. These people select their education level with high quality people being able to attain a higher education level at a lower cost. Employers look at education level and guess their productivity from that. They offer a wage as a result. When both parties happy that is the end.
The game shows how by signalling with education, the employer can make a better guess on who would likely be a good fit as the higher the education the more determination is required and this can be translated into a job.
Assume no signalling happened, what wage would employers offer and how does this affect low quality workers and high quality workers?
If paper, show this with maths.
Everyone would be offered the same wage, w. Low quality workers would be happy as this is higher than what they’d get, high quality would be not happy as this is lower than what they’d get.
High Q workers produce 2, Low Q workers produce 1. Population of L is q, Population of H is therefore 1-q.
High workers thus produce 2 (1-q) = 2-2q
Low workers produce 1 (q) = 1q
In population not everyone is H so the wage is lower than 2, not everyone is low so the wage is higher than 1
1q + 2 - 2q= 2-q, wage is 2> 2-q >1
Tell me about partial adverse selection, car market
Buyers may NEED to acquire a car, Sellers may NEED to sell a car and thus willing to pay more or accept less.
If buyer need car then more willing to pay a higher average price, if buyer value each unit for 1.2 and seller for 1 then the average price for seller would be lower than the buyer leading to producer surplus (seller only wanted 2500 for example but buyer willing to do 3000, 500 surplus)
How do universities for example make it so only high quality students signal
They make the signal such that it would be too costly for L quality to apply but not too high that H quality can’t achieve, thus those who apply most likely than not are H quality as it is ‘affordable’ for them to obtain.
