Lecture 27: Adverse selection

What are some problems with adverse selection?

Consumers might not make purchases to avoid being exploited by better informed sellers

What are some extreme case of adverse selection?

Can prevent markets from operation at all

What is market with imperfect information?

Market where at least one side is imperfectly informed

What is a market asymmetric information?

Imperfectly informed markets with one side better informed than the other

Which of these markets do you think has more asymmetric information?

The market for automotive repairs

Consider a used car market. • Two types of cars: "lemons" and "peaches". • Each lemon seller will accept $1,000; a buyer will pay at most $1,200. • Each peach seller will accept $2,000; a buyer will pay at most $2,400.What is the expected value to a buyer of any car?

EV = $1200(1- q) + $2400q

Suppose EV > $2000(the price of peach)>>>>

Every seller can negotiate a price between $2000 and $EV (no matter if the car is a lemon or a peach), sellers gain from being the market

Suppose EV < $2000

- Peach seller can't negotiate price above $2000 will exit the market
- so buyer know that remaining sellers would own lemons only
- buyer will pay most $1200 and only lemons are sold

Too many lemons crowd out the peaches from the market and the gains from trade_____________

are reduced since no peaches are traded

The presence of the lemons inflicts an_____________ on buyers and peach owners

External cost

If neither side knew which cars were lemons, peach sellers would?

Participate anyhow, no destruction of gains from trade

How many lemons can be in the market without crowding out the peaches?

Buyers will pay $2000 for a car only if EV = $1200(1 ) $2400 $2000

Practice Problem. What is the expected value of any car to a buyer is? Any car that a seller values at $x is valued by a buyer at $(x+300)

1500 + 300 = 1800, so seller who value their cars at more than 1800 exit the market

Practice Problem: What is the expected value of any remaining to a buyer is? Slidde 29

1400 + 300 = 1700, sellers who value their cars between 1700 and 1800 exit the market

Let Vh be the highest seller value of any car remaining, the expected seller value of a car?

1/2(1000)+1/2(Vh), so buyer will pay at most

What will be the price which seller of the highest value car remaining in the market will just accept?

1/2(1000)+1/2(Vh) + 300 = Vh

It costs $10 to produce a low—quality wallet and $20 to produce high quality wallet. Consumers can not distinguish the quality before purchase and do not make repeated purchases and value the good at the cost of production. There are 5 firms on the market. Each firm only produces high quality or low quality wallets. Consumers pay the expected value of the valets.Does any firm produce high-quality wallets?

No, It doesn't pay for one form to make high quality wallets if the other firms are making low quality wallets

Asymmetric information can destroy the market for_____

high quality food, which leads to loss in producer and consumer surplus