Week 8

Question 1

What question do we want to answer this week?

Answer 1

‘How markets function when quality of goods are known to some but not to others’

Question 2

What is adverse selection?

Answer 2

Economic situations which some agents hold private information that is not known to others. (hidden information)

Question 3

Imagine the market for used cars there are 100 sellers of used cars and 100 buyers. 50 cars are good and 50 cars are lemons.

For a good car sellers are willing to sell for a price above £2000 and lemon £1000

For buyers, they are willing to buy a good car max £2400 and bad car £1200.

Draw matrix for this?

Answer 3

Question 4

What can we see in this matrix for good cars vs bad cars?

Answer 4

If we start with a situation that is, if we didn’t have any aysmmetric information, namely if all players, buyers and sellers knew exactly what type of car they were buying, there is gains from trade.

Question 5

What would be adverse selection in the used car example?

Answer 5

Sellers know the type of car they are selling

Buyers cannot distinguish a lemon ( a bad car) from a good one.

Question 6

What is equilbrium in such a market?

Answer 6

○ Equilibrium is a stable situation in which:

■ All buyers and sellers have correct expectations about who, and what types, are in the market.

■ Market clearance: A Price for which demand equals supply.

Question 7

(What is the supply) If the Price is above 2000 what would be except?

Answer 7

When price is above 2000 we can see that both types of sellers are willing to sell at that price e.g. 1000<2000 and good car 2000< P. So both show up

Question 8

(What is the supply) If the Price is below 2000 but higher than 1000 what would be except?

Answer 8

This means that, this price is too low, for sellers who have the good cars, but the price is good enough for those that have lemons, so only lemons up for sale.

Question 9

(What is the supply) If the Price is below 1000 what would be except?

Answer 9

No cars are up for sale, this price is lower than willingless to sell.

Question 10

With demand, what are the prices going to tell us?

Answer 10

The prices are actually going to influence the demand curve, this didn’t happen in week 5, the price is going to tell the buyers, who should they except to see in the parking lot.

Question 11

(What about demand) So suppose if P was above 2000, what is the demand?

Answer 11

The buyers know the matrix, they know that everyone will come good and bad cars, because price is above willingness to sell for both of them, now id i execpt as a buyer all the cars are going to be on market i.e 100 cars, i cannot tell which is which (Aysmmetric info) , i do a 50% calculation so 1/2 of the time i am willing to pay £2400 and 1/2 i am willing to pay £1200, so my expected value of a car would be £1800. The P is greater than the expected value for them, so they are not willing to buy at that price. So demand is 0 at that price.

Question 12

(What about demand) So suppose if P is less than 2000 abut bigger than 1000, what is the demand?

Answer 12

Again the price is going to influence exceptions of buyers on who is going to come to the parking lot. They know that good cars are not going to come and the bad cars are, so they know every car they see is a lemon, they will only buy a car if P<1200, they will not demand any cars if P>1200, as willingness to pay is 1200.

Question 13

(What about demand) So suppose if P is less than 1000, what is the demand?

Answer 13

No cars are up for sale and so buyers know not to show up. So demand is 0

Question 14

What are some insights with the lemon and good cars example?

Answer 14

When we have aysmmetric infomation Price affects the willingness to pay (WTP) of buyers. the reason is that that the price reveals information to buyers about the quality of the goods that are sold!

Question 15

What is a good representational diagram for the market of used cars?

Answer 15

Question 16

What are key takeaways from the market of used cars example?

Answer 16

Only the worst quality goods will have a market.

● If the market exists, the price will be smaller than the average quality of the goods that could potentially be sold.

● Inefficiency (market failure): There are gains from trade that are left on the table

Question 17

What is health insurance?

Answer 17

Consumers buy a contract from insurance provider, pays a fixed fee called a premium, in an event of a loss, provider pays consumer an agreed a upon amount

Question 18

In the US is healthcare free?

Answer 18

No healthcare is privatelty owned, with exceptions, ( Veterans, Medicare( some old ) and Medicaid ( Some poor)

So lower middle class suffer

Question 19

So for old people they value health insurance high and young and restless value it less, the cost for old is smaller than young and restless, draw a matrix showing this?

Answer 19

Question 20

Lets make a model e.g. Assume 50% of the population are Old And 50% of the population are Young and restless.

The old value insurance at 2000 and young 800

The cost of insurance to provider for old is 3500

Cost of insurance to provider for young is 700

Draw matrix

Answer 20

Question 21

Suppose that insurance companies cannot discriminate between the two types of people.

Implication: The market will have a single price and a single plan!

Is a price above 2000 an equilbrium?

Answer 21

If price is above 2000, at that willlingness to pay for an old person is 2000, so if price is above 2000, no one will buy this, demand is 0. With supply, someoone wis willing to supply this as 700<2000, meaning profit, but there is not market clearance.

Question 22

Suppose that insurance companies cannot discriminate between the two types of people.

Implication: The market will have a single price and a single plan!

Is a price below 2000 but above 800 an equilbrium?

Answer 22

If this is the price, only the old people will buy this insurance, the price is above 800 so young will not want to pay as the most they are willing to pay is 800, so old are the only willing to pay.

But this cannot be equlibrium for old as, if the sellers have correct expectations as we assume that that happens in equilbrium about whos going to buy the product, thus the cost is going to be 3500>P, thus they are not willing to supply anything, so no equilbrium, there will be excess demand.

Question 23

Suppose that insurance companies cannot discriminate between the two types of people.

Implication: The market will have a single price and a single plan!

Is a price below £800 an equilbirum?

Answer 23

The young will buy this and old will buy this, as the price will affect the expected cost for insurers, thus they think the cost of producing ( half of the opeople taking my insurance old and young ( 3500+700)/2 = 2100, the cost>price. This cannot be an equilbirum in the market. The cost of insuring old is too much for the market to bear.

Question 24

So is there an equilbirum in the market?

Answer 24

So we cannot find an equilbrium in this market , when we don’t allow companies to distinguish between old and young, meaning no insurance will be provided by the market,

Question 25

Why is it not logical for there not to be an equilbirum in the market when companies cannot distinguish between old and young?

Answer 25

This is because there are gains from trade from young and restless ( they value the insurance more than cost to provide this), meaning there must be a price between 700 and 800 that we can sell to the young , which will make company and young happy.

Question 26

So without segmentation is there an equilbirum in the market here?

Answer 26

No

Question 27

Suppose now there is segementation in the market, providers distinguish between old and young, and can distinguish between the 2 different groups, will there be an equilbirum in the old market?

Answer 27

Noo price would work as Cost> benefit, thus no insurance provided for old.( if price was above 3500, ,making private insurers make profit, the buyers are not willing to pay prices <2000, in which will not cover the cost.

Question 28

At what price is an equilbrium in the young and restless market?

When there is segementation

Answer 28

If price is 700, this is an equilbrium ( this is because this is a compeititve equilbirum, when looking at market clearing, we assume market is competitive so lets say p =750, all buyers will be willing to pay and insurance companies will be willing to sell it, buy another company would sell for cheaper, so everyone goes to cheaper supplier, putting pressure to put price down.

There is excess supply when P = 701, so the Price of 700 is equilbirum as there is no excess supply or demand.

Question 29

What is a summary of equilbrium when providers can discriminate based on pre-existing conditions?

Answer 29

There is no insurance provided for old

There is insurance provided for young

SO old are unhappy and young are happy.

Question 30

When comparing market segementation to no market segementation, what can we say?

Answer 30

Pareto efficiency ( Market segementation better!, if you move from no market segementation to market segementation, there is an improvement as some people are made better off and no body is made worse off.

Question 31

With market segemenattion is it fair?

Answer 31

There is a large difference between old and younf in market segementation, at least when there is no market segementation no one is happy to the same degree

Question 32

What are some of the remedies that happened in america, when markets were shut e.g. poor, when markets were allowed to segement markets depending on pre exisiting conditions?

Answer 32

1. Universal Coverage (everyone gets medical insurance)
2. Subsidizing Coverage ( governement could subsidse the health insurance for poor and strickly)

Question 33

With obamacare which trump abonished what was his 3 main policies?

Answer 33

○ Expansion of Medicaid (subsidy, universal)

○ Individual mandate to purchase healthcare (universal) (force people to get health insurance)

○ Creation of insurance exchanges but forbidding companies from denying insurance to anyone (Banning Segmentation)

Question 34

Which of the following statements are true?

a. Adverse selection implies that equilibria in markets are always efficient.
b. Adverse selection implies that equilibria in markets are sometimes inefficient.
c. Adverse selection involves situations in which some individuals in the market have private information that others do not have.
d. Adverse selection involves situations in which all individuals in the market have the same information.
e. Adverse selection might imply that some goods cannot be exchanged in the market even though it would be mutually beneficial for buyers and sellers to trade these goods.

Answer 34

B C and E

For B look when we change numbers

Question 35

Which of the following statements are true?

a. Segmenting the health insurance market is always an inefficient thing to do.
b. If insurance companies do not sell insurance to some people in a free market, this is a sign that it is inefficient to provide these people with health insurance.
c. Pre-existing conditions in health insurance is a way insurance companies can segment the market.
d. There is no reason for government to intervene in the health insurance market.
e. A reason for a government to intervene in the health insurance market could stem from issues of adverse selection.

Answer 35

C and E are correct

B is not correct because False, in the example of health insurance we did in lectures, without segmentation the healthy were not insured, but it is efficient to supply them with insurance as their benefit outweighs the cost!

A is wrong as in lectures segmentation was actually the (Pareto) efficient thing to do.( doesn’t mean right thing)

Question 36

Which of the following statements are true?

a. If buyers could tell the type of the car when they see it, only lemons (bad cars) will be sold in this market.
b. If buyers could tell the type of the car when they see it, only good cars will be sold in this market.
c. If buyers could tell the type of the car when they see it, all cars will be sold in this market.
d. If buyers could tell the type of the car when they see it, no cars will be sold in this market.
e. If buyers could tell the type of the car when they see it, the equilibrium in this market will be efficient.

Answer 36

There are gains in trade for both so both are efficient, you can find an equibrium.

C and E are correct

Question 37

Which of the following statements are true?

a. If buyers could not tell the type of the car when they see it, if all sellers show up to the market, the buyer will be willing to pay £7000 for a car.
b. If buyers could not tell the type of the car when they see it, if all sellers show up to the market, the buyer will be willing to pay £1100 for a car.
c. If buyers could not tell the type of the car when they see it, if all sellers show up to the market, the buyer will be willing to pay £4000 for a car.
d. If buyers could not tell the type of the car when they see it, if all sellers show up to the market, the buyer will be willing to pay £4200 for a car.
e. If buyers could not tell the type of the car when they see it, if all sellers show up to the market, the buyer will be willing to pay at most £4050 for a car.

Answer 37

If buyers could not tell the type of the car when they see it, if all sellers show up to the market, how much will the buyer be willing to pay?

If all sellers show up and the buyer cannot tell which type the car is, then any car she sees she thinks that with half probability it is good and with half probability a lemon.

Therefore, she will calculate her expected value of the car to be: ½ £7000 + ½ £1100 = £4050 So she will be willing to buy for any price below £4050 and not willing for any price above!

SO b c and e are correct

Question 38

Question 3 Suppose that buyers cannot tell the type of the car. Which of the following statements are true?

a. A price above £5000 cannot be part of an equilibrium in this market.
b. There is an equilibrium in this market where the price is above £5000.
c. A price above £4050 cannot be a part of an equilibrium in this market
d. There is an equilibrium in this market where the price is £1100.
e. In the equilibrium of this market only lemons (bad cars) are sold.
f. In the equilibrium of this market only good cars are sold.

Answer 38

A C D E are correct

E is correct from lectures we saw that E was correct

Question 39

(Problem set)

Answer 39

If the equilibrium price is £160 that means that all types of sellers will post on the Sea-bnb website as this price is above the minimum price that they are willing to sell at.

Question 40

Given your initala answeer in (a) would buyers be willing to pay £160 for accomdation in Daskalio?

Answer 40

Given that all sellers post and that buyers cannot tell the quality of the flats by looking at the post, the buyer will be willing to pay at most the expected value of the flat. The expected value of the flat is computed by: 250+130+13/3 = 131

As price is bigger than 160 this means that there are no buyers will be willing to pay 160, as they don’t know which flat is which, they are only willing to pay $131.

Question 41

c. Using your answers above, argue why there cannot be an equilibrium with a price above £150 in equilibrium.

Answer 41

From (a) we know that when the price is £150 all seller types will post, that is 12 sellers post on Sea-bnb. But from (b) we know that buyers are not willing to pay more than £131, so they will not buy. Therefore this cannot be an equilibrium; as the number of sellers willing to sell (12) is larger than the number of buyers wanting to buy (0)

Question 42

d. Suppose now that the equilibrium price is £120. What types of sellers would be posting on Sea-bnb?

Answer 42

If the equilibrium price is £120 that means that just the OK and awful types of the sellers will post on the Sea-bnb website as this price is above the minimum price that they are willing to sell at. The price is too low for the amazing flats to post!

Question 43

e. Given your answer in (d), would buyers be willing to pay £120 for accommodation in Daskalio?

Answer 43

Given that only the OK and awful sellers post and that buyers cannot tell the quality of the flats by looking at the post, the buyer will be willing to pay at most the expected value of the flat. The expected value of the flat is computed by: 130+13/2 = 71.5

As 71.5>120 these buyers are only willing to pay 71.50 . Thus the buyers would not be willing to pay £120 for accomdation in Daskalio

Question 44

f. Using your answers above, argue why there cannot be an equilibrium with a price above £120 in equilibrium.

Answer 44

From (d) we know that when the price is £120 just the OK and awful seller types will post, that is 8 sellers post on Sea-bnb. But from (e) we know that buyers are not willing to pay more than £71.5 so they will not buy. Therefore this cannot be an equilibrium; as the number of sellers willing to sell (8) is larger than the number of buyers wanting to buy (0).

Question 45

g. Suppose that the price posted in equilibrium is £13. Argue why this corresponds to an equilibrium in the market. In your description of the equilibrium please state which sellers are posting on Sea-bnb and how many buyers are renting flats.

Answer 45

If the equilibrium price is £13 that means that just the Awful types of the sellers will post on the Sea-bnb website as this price is above the minimum price that they are willing to sell at. The price is too low for the OK and Amazing flats to post. Given that only Awful types are posting, buyers correctly understand that the flats are awful. They are willing to pay £13 for such flats but the price is £13 so they are happy to buy at this price! This is an equilibrium as 4 sellers are willing to post at the price of £13 and 4 buyers are willing to buy. ( There are gains from trade)

Question 46

h. What would be the equilibrium if the buyers could tell the quality of the flats by looking at the posts?

Answer 46

In this case, there will be three different prices, one for each type of flat. Given that there are more buyers than flats the price of each type of flat in equilibrium must be such that buyers are indifferent between renting or not. If the prices are lower, we will have excess demand, which will create pressure on prices to increase. As a result, the equilibrium prices will be: A

mazing flats will go for £250

OK flats will go for £130

Awful flats will go for £13

Question 47

Compare this situation to the one you analysed in (g). Can you say that one situation (equilibrium) is better than the other? Explain the reasoning behind your answer.

Coninutation of G

Effciency vs equality

Answer 47

1. Efficiency: By efficiency, we ask what happened to the sum of consumer and producer surplus? In the equilibrium in (g) only 4 sellers got surplus from renting out the awful flats; they got 13 for a flat they valued at 10. The other sellers did not rent their flats and so got no surplus at all. All the buyers did not get any surplus as they either did not rent a flat or they rented at the price 13 which was their willingness to pay. In (h) in comparison, all sellers get surplus and the ones that got surplus in (g) get the same surplus here. All buyers have zero surplus in (h) as they all buy at their willingness to pay. Therefore, the equilibrium in (h) is more efficient! ( explain how people are better off in H, pareto efficiency, okay and awful flats)
2. Equality: The situation in (g) is less equal than the one under (h) as in (h) all sellers get surplus and in (g) only the sellers of awful flats!

Question 48

Lets look at adverse selection in the labour market assume there are 2 different types of applicants distrubted equally, high and low abilitiy

High ability providers employee with revenue =10

Low ability providers employee with revenue = 2

Assume high ability applicants only work if wage is strictly higher than 7 and low ability workers work for any wage.

What happens when i post a wage of higher thana 7

Answer 48

All applicants apply, employers don’t know anything about whether they are high ability or low ability, hence they yield revenue = 1/2 X 10 + 1/2 x 2 = 6. So if i pay wage higher than 7, this attracts high ability pupils and low ability, what my expected value is 6, so im paying more than i get,thus i cannot hire high ability candidates as cost> revenue, showing adverse selction in labour markets.

Question 49

What doess the spence model show?

Answer 49

How do universities help the employers and the applicants.

Question 50

What assumptions are we going to make in the spence model?

Answer 50

: Applicants learn nothing in uni

○ So going to uni does not change applicant’s’ abilities or the revenue they yield to employers ( 10 and 2 doesnt change)

Also studying for the high ability applicants has a cost of 5

Studying for the low ability applicants has a cost of 12

Question 51

Lets now say LSE post a wage of 10 but requires a uni dipolma ( LSE graudate, but both low ability and high ability applicants go to lse,

If high ability applicants go uni and lose 5

and gain 10

and low ability applicants go uni and lose 12

and gain 10,

what is the best advice ?

Answer 51

Low ability applicants ( Better not to go to uni as 10<12

High ability applicants (Better to go to uni and apply for the job 10>5)

Question 52

What does spence model say?

Answer 52

Universites play a role of segementing the market, this allows employees to screen between applicants of different abilities( they can now ask applicants if they have a degree)

This suggests a positive correlation of going to uni and employment.

Question 53

What is one reason we buy designer clothes

Answer 53

One reason we buy designer clothes , because it signalles, that we want to match with people like us ( rich people)

If we didn’t wear clothes, we couldn’t tell what people were like, but designer clothes signal this( this issue with adverse selection is that we do not know alot about each other)

Adverse selection gives rise to giffen goods