ECON 1116 26 NovemberMarket 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 marketo Consumers may know more Ex: auto insurance marketo This asymmetry distorts economic decisions and prevents mutually-beneficial transactionso 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- Each state of the world is one possible realization of the random variable- 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 selectiona. Arises from private information about characteristicsb. Describes market composition2. Moral Hazarda. Arises from private information about behaviorb. Describes market actions- “The Lemon Problem” and asymmetric informationo 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 occuro Market participants 100 buyers of used cars 100 sellers of used carso Knowledge ¾ of cars are good (peaches) ¼ of cars are bad (lemons) The seller knows if his car is a lemon or a peach The buyer cannot distinguish between lemons and peacheso Valuations Sellers:ECON 1116 26 November- Value peaches at $2000- Value lemons at $1000 Buyers:- Value peaches at $2400- Value lemons at $1200o Intuition: With complete information:- 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 onepriceo Calculations: 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) = $2100o Both lemons and peaches will sell because the sellers value both lemons and peaches less than $2100- Adverse selectiono Ex: health insurance 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 premiumso Combatting: 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 signalo Ex: used car warranteeso Ex: education signals that you are high-productivityECON 1116 26 November- Moral hazardo 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 insuredo Combatting: Need to give incentive to exert effort- Ex: sales commissions- Ex: insurance deductibleso Coverage is less than 100% so people aren’t completely reckless with the assurance that someone else is paying in
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