Overview: Asymmetric Information and Market Structure Bargaining Games Asymmetric Information (hidden attributes) • The “Lemons” problem • Adverse Selection • Solutions Bargaining Games : Introduction • You will bargain over a car. • Cars can be either good or bad. Half the cars currently owned by potential sellers are good and half are bad. • A good car is worth $7000 to a seller (S), while a bad car is worth only $2000 to a seller. • A potential buyer (B) always values the car $2000 more than the seller. A good car is thus worth $9000 to a buyer, while a bad car is worth $4000. • The above facts are common knowledge among buyers and sellers. 1Bargaining Game I • Instructions – Bargaining on whether to sell and at what price (you may refuse to trade) – Record • whether you reached an agreement • if so, at what price • how long it took to get agreement Bargaining Game II • Instructions – Bargain on whether to sell and at what price (you may refuse to sell) – You ARE allowed to make any claim about your actual value. (Remember though that everyone knows the distribution over possible values). – You are NOT allowed to give any personal assurances that your claims are true, such as promise a beer if you lie. – Record • whether you reached an agreement • if so, at what price • how long it took to get agreement 2Questions We’ll Address: • What are the implications of asymmetric information for market equilibrium and market structure? • What can firms (or governments) do in such cases? 3Examples of Asymmetric Information • What happens when sellers know much more than buyers about the quality of a good that’s being offered for sale? • The market for “lemons” Bargaining Game II: Market Failure • Note, expected value of car to B is .5 * 4000 + .5 * 9000 = 6500 => Buyer would not pay more than 6500 • At a price less than 7000, no good cars will be offered • With only bad cars offered, equilibrium prices could be at most 4000. • In equilibrium, only bad cars traded, at price between 2000 and 4000. 4Market Responses to Asymmetric Information • Sellers have strong incentives to provide information regarding product quality, but … • Solutions to “market failure” caused by asymmetric information – by private firms – by government 5Adverse Selection • Refers to how health insurance tends to attract people with highest health risks • Arises because insurance companies cannot observe an individual’s health • Other examples of adverse selection Harvard’s “Death Spiral” Experience with Adverse Selection Total Total Employee Premium Premium Premium % BC/BS BC/BS HMO BC/BS Enrollees 1994 6,600 6,400 600 20 1995 6,400 5,500 1,050 15 1996 7,400 5,300 2,400 9 1997 Disbanded Disbanded 6“SLOAN MBA” Why do employers trust this signal? 7Diplomas as Signals • People with greater productive ability are more likely to attain a higher education level, signaling their productivity and thereby obtaining better-paying jobs and • Firms are correct in considering educational attainment a signal of productive ability Simple Example from Text • Two types of workers - high ability and low ability (50/50) • Value of employing high ability worker - $200,000 • Value of employing low ability worker - $100,000 • Cost of y years of college (financial + psychic): – $20,000y for high ability workers – $40,000y for low ability workers • Note: here education doesn’t increase productivity • Perfect information vs. Asymmetric information 89“Our Product Tastes Great” • Is this credible? • When might it be? Information and Incentives • Most situations involve several information phenomena – Adverse Selection – Signaling and Screening – Moral Hazard • Volvo drivers • Free eyeglasses • Start-ups and venture capital • VPI Insurance 10Start-Ups and Venture Capital • Information Issues with Start-Ups – Adverse Selection • Which ideas have potential for big markets, sustainable profits? • Do management teams have ability to make business a success? – Moral Hazard • Will management teams work hard enough? • Venture Capital Markets – VC’s demand evidence of ongoing revenue, insist on severe conditions for lending – Market failure: VC’s have money but no one gets it. Features of VPI’s 2004 Insurance Policy • Eligibility: – Any individual 8 weeks old and up, no age limit. – No pre-existing conditions • Coverage: – Most medical treatments and hospitalization, including mental health – Choose your own health care provider – No cosmetic surgery – Dollar cap for each condition (e.g., $300 for bladder infection) • Cost Sharing: – 80% of first $180 per incident – $50 deductible per visit 11Take Away Points • Asymmetric Information can cause markets to fail. • Adverse selection occurs when exactly the people with the worst characteristics accept the deal. • To solve such information problems, you need credible communication. • Signaling, screening, and warranties can provide credibility.