ECON 1116 26 November Market failure due to imperfect asymmetric information Asymmetric information some agents have information that others do not i e private information o Producers know more about price relevant characteristics of good Ex used car market o Consumers may know more Ex auto insurance market o This asymmetry distorts economic decisions and prevents mutually beneficial transactions o Creates roles for uncertainty expectations Some calculations o A random variable is a variable with an uncertain value With this uncertainty we generate different potential states of the world random variable Each state of the world is one possible realization of the All states are not equally likely so each has a probability attached to it Expected value of this random variable is defined as the weighted average of all possible values E Y P1 Y1 P2 Y2 PN YN Asymmetric information distorts decisions in two ways 1 Adverse selection a Arises from private information about characteristics b Describes market composition 2 Moral Hazard a Arises from private information about behavior b Describes market actions The Lemon Problem and asymmetric information o George Akerlof 1970 paper The Market for Lemons Illustrated how asymmetric information can cause market failure Possible loss of social surplus and inefficiency Welfare improving transactions do not occur o Market participants 100 buyers of used cars 100 sellers of used cars o Knowledge of cars are good peaches of cars are bad lemons The seller knows if his car is a lemon or a peach The buyer cannot distinguish between lemons and peaches o Valuations Sellers ECON 1116 26 November Buyers Value peaches at 2000 Value lemons at 1000 Value peaches at 2400 Value lemons at 1200 o Intuition With complete information Adverse selection o Ex health insurance Good and bad cars sell for different prices A lemon cannot pretend it s a peach With asymmetric information Buyers cannot distinguish quality so all cars sell for one o Calculations price Unknown car quality is a random variable State 1 car is a lemon State 2 car is a peach Expected benefit value to buyer determines the price in this case E buyer value probability lemon value of a lemon probability peach value of a peach E value 1 4 1200 3 4 2400 2100 o Both lemons and peaches will sell because the sellers value both lemons and peaches less than 2100 o Combatting Insurance companies will face higher probability of insuring at risk individuals because healthy people won t pay high premiums Adverse selection death spiral keep raising premiums Screening agents without private information Use observable information to make inferences about private information Car insurance will charge sixteen year old males more than middle aged people health insurance Signaling agents with private information Take action that tries to credibly reveal private information If signal is relatively more costly to bad prospects then those that are good prospects will be more likely to signal o Ex used car warrantees o Ex education signals that you are high productivity ECON 1116 Moral hazard 26 November o Can distort agents incentives to take care or exert effort when other agents bear the cost of lack of care or effort Insurance markets Health start smoking stop exercising once insured o Combatting Need to give incentive to exert effort Ex sales commissions Ex insurance deductibles o Coverage is less than 100 so people aren t completely reckless with the assurance that someone else is paying in totality
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