WEEK 9 - Asymmetric Information Flashcards
What happens when consumers have perfect information?
Receive all benefits from trade.
Due to firms consistently undercutting one another.
Leads to Price at MC levels
What happens when Consumers have imperfect/ Asymmetric information?
When all consumers are uninformed about prices and finding out information is costly, receive none of the benefits from trade.
Price is set at Monopoly.
What is Imperfect Information?
Buyer lacks information about prices.
Buyers behaviour determines how informed they are.
A lack of information provides firms with market power.
What is the Unravelling Principle?
Firms can have incentives to provide information to uninformed consumers.
Under certain conditions firms may provide full information.
When does the Unravelling Principles hold?
- There are differences between products which consumers care about (i.e Quality)
- Firms can make costless, credible statements about their products
What is the logic behind the Unravelling Principle?
E.G Kebab Shop.
If they show you their hygiene scores, the one with the best hygiene score has incentive to show consumers they are the best.
Once one firm shows information, next best store has incentive to provide information since the best firm cannot supply everyone.
-If firms have no information and will assess all firms as ‘average’. They will purchase from stores at random.
What can we use as an example for the Unravelling Principle? (Helps to explain the logic behind the Unravelling Principle)
Suppose there are 3 firms in the market: A, B and C
A is high quality: offers a consumer a surplus of 3
B is medium quality: offers a consumer a surplus of 2
C is low quality: offers a consumer a surplus of 1
If consumers are uninformed, they will perceive all firms as average where
Average surplus is: (1 + 2 + 3)/3 = 2
An uniformed consumer will shop at random and expect to receive a surplus of 2
Each firm will receive one third of the consumers
… But A can do better if it reveals that it is above average
It’s profits increase because more consumers will visit it, since 3 > 2
Given A has revealed its information, all consumers will want to purchase from it
But they may not be able to supply everybody!
An uninformed consumer will now perceive B & C as average
Average surplus is then: (1 + 2)/2 = 1.5
An uniformed consumer will shop at random and expect to receive a surplus of 1.5
Each firm will receive a half of the left over consumers
But now B can do better if it reveals that it is above average, 2 > 1.5
ETC.
What is Asymmetric Information?
When one party has more information than the other.
Can lead to the market under providing high quality goods.
In many cases buyers have more info than sellers (Usually about quality)
What are the 3 types of goods related to Asymmetric Information?
- Search Goods: Easy to assess quality pre-purchase
- Experience Goods: Difficult to assess quality pre-purchase but can post-purchase (e.g Holiday)
- Credence Goods: Difficult to assess pre and post purchase (E.g Skin Care)
What is the Problem in markets with Asymmetric Information?
The Problem of Adverse Selection: High quality products may not be sold in the market.
EXAMPLE:
Suppose a firm has an equal number of high- and low-quality cars
To buy the cars, it costs the firm :
- £3000 for a high quality car
- £100 for a low quality car
Consumers are willing to pay:
- £4000 for a high quality car
- £1000 for a low quality car
The firm could make: £1000 from selling a high quality car
£900 from selling a low quality car
But consumers cannot tell which cars are high-quality and which are low quality
Average willingness to pay is: (4000 + 1000)/2 = £2500
An uniformed consumer who picks a car at random will be willing to pay £2500
The consumer only willing to pay £2500
But the salesperson is only willing to sell low quality cars at this price
The cost to the firm for a high quality car is £3000
The cost to the firm for a low quality car is £100
The salesperson would make a loss of at least £500 from selling a high quality car!
Only low-quality cars will be bought and sold: no market for high quality cars
THE SELECTION OF CARS ADVERSELY AFFECTED BY THE ASYMMETRIC INFORMATION
What are the solutions to Informational Problems?
- Signalling:
Make high-quality claim credible e.g Offer warranty - Screening: Buyer get information on firms’ reputation e.g customer reviews
In other situation, Govt may be forced to fix the market
- Govt Intervention: Minimum standards, Verify firms’ claims, Provide information to buyers
What are the problems of Asymmetric Info?
- Adverse selection. Bad sellers drive out the good ones.
- Moral hazard. The incentive to provide good products or services is reduced.
A variant on this is the principal-agent problem.
In principle, adverse selection and/or moral hazard can cause markets to disappear completely.
What are the differing types of signals that can be used
A test by a reputable third party.
Some kind of warrantee
What are some of the examples of markets that adverse selection can affect?
Adverse selection can affect all kinds of markets, such as labour markets (Spence) or insurance markets (Rothschild and Stiglitz).
How is education a signalling effect?
Spence showed takes more work for a slow learner to get an A-level than for a fast learner. So lots of good exam results signal a person is intelligent and hard-working.
