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Asymmetric Information Perloff Chapter 19. Asymmetric Information When two parties to a transaction have different information. Adverse Selection –When.

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Presentation on theme: "Asymmetric Information Perloff Chapter 19. Asymmetric Information When two parties to a transaction have different information. Adverse Selection –When."— Presentation transcript:

1 Asymmetric Information Perloff Chapter 19

2 Asymmetric Information When two parties to a transaction have different information. Adverse Selection –When an informed person has an advantage through an unobserved characteristic. –Eg a disproportionately large number of unhealthy people buy life insurance. Moral Hazard –When an informed person has an advantage through an unobserved action. –An insured car driver drives faster.

3 Equalising information Screening –Obtaining information about hidden characteristics. –Insurance. –Costly. Signalling –Use of public information to indicate the nature of private information. –Restaurant.

4 Market for lemons and good cars Lemons per year 1,000 S L D L D *1,500 1,000 (a) Market for Lemons f e Price of a lemon, $ 2,000 Good cars per year 1,000 S 2 S 1 D G D * 1,750 1,500 1,250 0 (b) Market for Good Cars F E Price of a good car, $

5 Preventing the occurrence of lemon markets Laws –Product liability laws, Consumer screening –The use of a mechanic, –Reputation, Third party comparisons, –Which reports, Standards and certification, –Kite marks, Signalling by firms –Brand names to differentiate product.

6 Price Discrimination Through Asymmetric Information Charge a different price according to willingness to pay. Some consumers may falsely believe a product is of a higher quality. Own label product.

7 Tourist Trap Model Pure competitive market: – All firms charge the same price. –A higher price results in zero demand. Imperfect information in a competitive market. –Know the prices charged by shops but not specific price charged by a specific shop. –Competitive price is p*. –Firm can charge p*+e. –e is less than cost of finding another shop.

8 Monopoly price in a tourist trap Suppose all firms charge p*+e –Same reasoning implies all firms can raise price to p*+2e This argument can continue to be applied until all firms charge the monopoly price. –At this price further price increases result in a loss of profit. In a market where finding prices is costly the equilibrium price is the monopoly price. If firms are allowed to advertise prices so that search costs disappear the competitive price results.

9 Employee safety with asymmetric information Employees in safer industries pay lower wages than in unsafe. Safety statistics are reported at industry levels, not the firm level.

10 Lying to a potential employer?

11 Education as a signal Low ability people will not graduate. –Have to accept lower unskilled wage. High ability people will go to college if difference between skilled and unskilled wage exceeds cost of education Two equilibrea are possible –Pooling When costs of education exceed the wage differential and everyone is paid the same. –Seperating When it pays to go to college.

12 Pooling and separating equilibrea

13 Unique or multiple equilibrea 20,000 q, Share of high-ability workers q = 1 – c w h – w l c =w h – w l 101 – 4 1 – 2 15,000 5,000 Separating equilibrium Pooling or separating equilibrium Pooling equilibrium x z y c, Cost per diploma, $


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