1. Asymmetric information

What is Asymmetric information?

when either buyers or sellers lack information about the market in which they are buying or selling, is a possible cause of market failure

What are the main 3 problems of asymmetric information?

• the market for lemons - lemon = low quality, peach = high quality

• Quality choice - cant tell if they are high risk/low risk - high risk needs more insurance

• Adverse selection and moral hazard - change in behaviour bc/ of insurance

• Signalling - hidden information - can u do something to reveal the information

What does analysis of markets assume?

buyers and sellers are fully informed about the market in which they are buying and selling - no mistakes

• someone doesnt buy/sell something for different valuation - buyer values it more than seller→ market efficiency

• any exchange benefits both buyer and seller are made

What problems does asymmetric information create?

creates problems for market efficiency

What is the market for lemons?

In market there is 2 quality points: high and low

Both buyers and sellers have different valuations of the good depending on its quality - sellers know what quality their car is.

If the quality of cars is unknown to the buyer, what is the equation for the expected valuation of the car?

(0.5)(highest end value of low value car) +(0.5)(highest end value of high value car)

Who will sell the car if it is at a valuation where the buyer doesn’t know the quality?

It is below valuation of high-quality sellers → only low-quality cars will be sold → buyers know it will be low quality → not worth buying → only market for low-quality cars → NO MARKET FOR HIGH QUALITY SELLERS

What happens even though there are high quality cars/

there are ppl who value them more than their seller → Pareto improvement needs to happen for exchange to happen → market will not operate

Can we avoid the problem of market for lemons?

• find a way high-quality sellers can show the quality of their cars to consumers

• low-quality sellers can’t be able to copy this, for it to be credible

• Example: warranty e.g. offer free repairs for a year after the car is sold

To be able to solve the problems of market for lemons what conditions must hold?

• warranty must be credible, e.g. legally binding agreement → they know itll hold

  • Example: agreement that the car will be repaired - low quality won’t be able to fix all the low quality as they will lose money

• too expensive for the low-quality seller to copy → they don’t want to make a loss

What is quality choice?

producers choose a quality level for their product

• assume consumers can’t observe the quality → consumers willing to pay reservation prices (rH) for high quality or rL for a low-quality product

• large no of sellers w/ proportion q selling the high-quality product

  • proportion 1-q = low quality products

If both qualities have the same unit production cost will there be a market for this product? RL <c< RH

They happy to pay for high quality but not low quality

• assume: customers are aware of the average quality of the product + buy if their expected valuation is at least as high as the price

What is the condition for consumers to be willing to buy in quality choice?

What would be the equation for q?

this lies btw 0 and 1: must be high enough share of high quality for consumers to be willing to buy the good

question: why producers choose to produce low quality if cost is ame —> making it less likely ppl will buy it