SC ECON 221 - Asymmetric Information (4 pages)

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Asymmetric Information

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Asymmetric Information


This lecture discusses the concept of asymmetric information and specifics regarding this concept such as: uncertainty, risk aversion, moral hazard and adverse selection.

Lecture number:
Lecture Note
University Of South Carolina-Columbia
Econ 221 - Prin of Microeconomics
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ECON 221 Lecture 20 Outline of Last Lecture I Oligopoly characteristics II Game theory a Strategic Interaction b Dominant Strategy III Maximizing Profits IV Tacit Collusion Outline of Current Lecture I Uncertainty II Asymmetric Information a Adverse Selection b Moral Hazard III Expected Value IV Risk Aversion Current Lecture Asymmetric Information Lecture 21 How do we model decision making under uncertainty Example Why does a used car even if barely used cost so much less o Buying a car especially used is hard Is the car going to break down soon Are there issues with the car Hard to tell o Uncertainty lowers the price What does that mean These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute People with NICE used cars that should receive a higher than average price won t sell Can t get the money the car deserves So all or most of the used cars being sold are probably have trouble that the OWNER knows about but the buyer doesn t Increases uncertainty even more lowers price even more Uncertainty Asymmetric information one party seller has better information than the other buyer o Has an impact on economic behavior and outcomes o Lots of situations like this Is the local nursing home taking good care of my grandparents Is this private school really going to do a better job of educating my kids Is the person I m hiring going to be a good worker Two big problems that can arise under asymmetric info o Adverse selection o Moral hazard Adverse Selection As in the car example asymmetric information can lead to adverse selection o Because the seller has more info than the buyer the seller has an incentive to sell the worst things o Similarly when deciding whether to buy insurance or not you don t know whether you re going to get sick but you know more about your lifestyle than the insurance company As a result people who expect to be healthy don t buy insurance Those that expect to be sick buy insurance o The presence of private information and selection based on this information makes health insurance very different than markets for most standard goods like broccoli This is one argument for government involvement that can improve efficiency by preventing this spiral from occurring Moral Hazard Another problem that results from asymmetric information is moral hazard when individuals know more about their actions than others do o Problematic when cost of action or inaction is suffered by others If I m a worker in an office my boss can t perfectly observe my ac0ons so I have little incentive to work hard but he still has to pay me A solution Changing decision maker s environment so she must respond to relevant incentives e g give employee shares of stock franchising fast food restaurants etc Adverse Selection and Moral Hazard These concepts sound similar but keep in mind o Adverse selection arises when one party knows more about the state of the world Another example You apply for a job The employer is unsure whether you re productive or unproductive in part because every worker makes themself look as though they re productive Resulting inefficiency o Moral hazard arises when one party knows more about her own actions Another example Your buy insurance against theft in your apartment and after doing so you become less careful about locking doors etc Resulting inefficiency How are these situations modeled o We need to back up and think about how economists model any situation where people are uncertain o Key question How do we think about willingness to pay when I m uncertain of what I m buying Choices measure willingness to pay for a good where you were uncertain of its value Expected Value o Expected value measures what you can EXPECT the outcome to be NOT what you should be willing to pay Risk Aversion Max willing to pay is lower than Expected Value o Modeled after Diminishing Marginal Benefit o Consider the market for insurance The market for insurance is entirely driven by the presence of risk Ex A family decides whether to buy health insurance each year There s a 50 chance someone will get sick without insurance medical bills would be 10 000 But there s also a 50 chance the insurance is unnecessary 0 in medical bills even w o insurance o Medical expenses in this example are a random variable a variable with an uncertain outcome in the future they might be either 0 or 10 000 in a given year o We don t know whether someone will get sick but we can calculate how much they would expect to pay per year o Expected Value of Medical Expenses per year Good outcome X 1 2 Bad outcome X 1 2 10 000 1 2 0 1 2 5 000 The family w o insurance can expect to pay 5 000 a year even though some years they ll pay 0 and some years they ll pay 10 000 o This tells us something about how much they d be willing to pay for insurance They d almost certainly buy any insurance plan that costs less than or equal to 5 000 a year Why If insurance costs 5000 in the long run costs are the same No insurance 10 000 x 25 250 000 Insurance 5 000 x 50 250 000 o As a result this is called a fair insurance policy o Anything less than 5 000 and expected payment is strictly lower with insurance

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