Module 11.1 Adverse Selection Lecture

Asymmetric Information

• Definition: Occurs when one party in a transaction knows more than the other, leading to discrepancies in decision-making.

• Examples include hidden characteristics and hidden actions.

Hidden Characteristics

• Definition: Attributes about the goods or services that one party knows but the other does not.

• Used Cars Example:

• Sellers know more about the condition of the car than buyers.

• Potential issues (maintenance, previous usage) are concealed from the buyer.

Adverse Selection

• Definition: A situation where sellers have private information about the quality of a product, leading to a market where only lower quality goods are available.

• Example:

• High-quality car worth $5,000; low-quality car (lemon) worth $0.

• If the buyer can’t distinguish between them, they will only be willing to pay based on average expectations.

• If there's a 50% chance of getting a lemon, they will only offer $2,500.

• Result:

• Sellers of high-quality cars (worth $4,000 or more) won’t sell at this price, leading to their exit from the market.

• Only lemons remain, resulting in a dysfunctional market.

Moral Hazard

• Definition: A situation where one party can take actions that are unobservable by the other party, leading to riskier behavior.

• Example:

• Employees slacking off when the boss isn’t watching (the incentive changes when monitoring is absent).

Market Failure due to Asymmetric Information

• If quality cannot be determined due to asymmetric information, only poor quality goods are left for sale.

• New cars depreciate sharply because of perceived hidden issues; buyers suspect something is wrong if someone sells a new car.

George Akerloff’s Contribution

• A Nobel laureate who outlined the adverse selection problem in 1970.

• Clarified how hidden characteristics can lead to market failure as informed sellers stay out of the market.

Information Solutions

• Increasing access to information can mitigate problems of asymmetric information:

• Technology allows potential buyers to check vehicle history easily.

• GPS tracking in taxis helps passengers avoid being overcharged.

• Online reviews and ratings increase accountability among sellers.

• Reputation becomes crucial in maintaining trust in such transactions.

Future Considerations

• Next discussions will cover situations where buyers hold private information, such as in health insurance markets.

• Addressing asymmetric information could lead to more efficient markets by encouraging transparency and better information flow.