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Berkeley ECON 100A - Asymmetric Information

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Asymmetric InformationMain topicsProblems due to asymmetric informationTypes of opportunistic behaviorAdverse selectionAdverse selection market failureMoral hazardMoral hazard not necessarily harmfulResponses to adverse selectionRestrict opportunistic behaviorMeans of equalizing informationHow ignorance about quality drives out high-quality goodsLemons market buyersLemons market sellersTwo possible equilibriumValue to sellers of good cars is $1,250Markets for LemonsMarkets for Good CarsValue to sellers of good cars is $1,750Lemons market with variable qualityLimiting lemonsPrice discrimination due to false beliefs about qualityPrice ignorance  market powerTourist-trap modelIs a competitive price charged?Monopoly priceProblems arising from ignorance when hiringCheap talkEducation as a signalExampleTwo types of equilibriaPooling equilibriumSeparating equilibriumIs separating equilibrium possible?Is pooling equilibrium possible?Solved problemAnswerUnique or multiple equilibriaPooling and Separating EquilibriaEfficiencyEveryone may lose in a separating equilibriumAsymmetric InformationMain topics•problems due to asymmetric information•response to adverse selection•how ignorance about quality drives out high-quality goods•price discrimination due to false beliefs about quality•market power from price ignorance•problems arising from ignorance when hiringProblems due to asymmetric information•if both parties to a transaction have limited info, neither has an advantage•asymmetric info leads to opportunism, whereby informed person benefits at expense of those with less infoTypes of opportunistic behavior•adverse selection•moral hazardAdverse selection•opportunism characterized by •an informed person’s benefiting trading (contracting) with less informed person •who does not know about an unobserved characteristic of the informed person•people who buy life insurance know more about their own health than does the insurance companyAdverse selection market failure•reduces size of a market (possibly eliminating it)•example: few older people regardless of their health buy term life insurance because rates are extremely high because of adverse selectionMoral hazard•opportunism characterized by an informed person taking advantage of a less-informed person through an unobserved action•examples•sleezeball sells you swamp land in Florida•employee shirks if not monitored by employerMoral hazard not necessarily harmful•pregnant women with health insurance make more prenatal doctor visits•extra cost bad for insurance firms, but society benefits from healthier women and babiesResponses to adverse selection main methods for solving adverse selection problems are to•restrict opportunistic behavior•equalize informationRestrict opportunistic behavior•universal coverage: provide insurance to all employees of a firm•thus both healthy and unhealthy people are covered•firm buys medical insurance at a lower cost per person than workers could obtain on their own (where relatively more unhealthy individuals buy insurance)Means of equalizing information•screening •action taken by an uninformed person to determine info possessed by informed people•buyer test drives many used cars•signaling•action taken by an informed person to send information to a less-informed person•firm distributes a favorable report on its product by an independent testing agency to prove its quality is highHow ignorance about quality drives out high-quality goods•buyer cannot judge a product’s quality before purchasing it•low-quality cars – lemons – may drive high quality products out of the market (Akerlof)•owners of lemons are more likely to sell their cars, leading to adverse selectionLemons market buyers•many potential buyers for used cars•all are willing to pay•$1,000 for a lemon•$2,000 for a good used carLemons market sellers•owners willing to sell up to•1,000 lemons•1,000 good used cars•reservation price of owners (lowest price at which they’ll sell their cars)•$750 for lemons•$1,250 or $1,750 for good carsTwo possible equilibrium•all cars sell at average price, $1,500 (sellers of good cars are implicitly subsidizing sellers of lemons)•only lemons sell for a price equal to the value that buyers place on lemons (bad drives out good)Value to sellers of good cars is $1,250•sellers willing to sell their cars at average price ($1,500)•equilibrium price $1,500 in both markets•lemons market equilibrium: f, intersection of SL and D*•good market equilibrium: F, intersection of S1 and D*•asymmetric information does not cause an efficiency problem, but has equity implicationsMarkets for LemonsMarkets for Good CarsValue to sellers of good cars is $1,750•lemons drive good cars out of market•buyers know that only cars they can buy at < $1,750 is a lemon•lemons sell for $1,000: e, intersection of SL and DL•equilibrium is inefficient: high quality cars remain in hands of people who value them < than do potential buyersLemons market with variable quality•many firms can vary quality of their products•if consumers cannot identify quality•all goods sell at same price•raising your quality raises average price of all firms•inadequate incentive to produce high quality•social value of raising the quality is greater than the private valueLimiting lemons•laws to prevent opportunism•consumer screening •third-party comparisons•standards and certification•standard: metric or scale for evaluating the quality of a particular product (e.g., R-value of insulation)•certification: report that a particular product meets or exceeds a given standard level•signaling by firms•guarantees and warranties•brand namePrice discrimination due to false beliefs about quality•noisy monopoly•multiple brand names•refrigerators•Amana and Kenmore•Whirlpool and Kenmore•cars•Ford Taurus & Mercury Sable•Toyota Camry & Lexus ES 300•Dodge Colt, Mitsubishi Mirage, Plymouth Colt, & Eagle Summit•Bentley Brookland ($152,400) & Rolls-Royce Silver Spur III ($178,200)Price ignorance  market power•limited information about price leads to market power•consumers who do not know that a product can be bought for less elsewhere buy from high-price storesTourist-trap model•many souvenir shops•guidebook tells distribution of prices•costs tourist c in time and expenses to visit a shop and


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