Information. Information Problems Adverse Selection: The Market for Lemons Two types of cars: ½ are good cars ($100) and ½ are lemons ($50). Sellers know.

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Information

Information Problems Adverse Selection: The Market for Lemons Two types of cars: ½ are good cars ($100) and ½ are lemons ($50). Sellers know if the car is a good car or a lemon but buyers do not. The quality of the car is not observable to buyers. Suppose that buyers, knowing that ½ of the cars are lemons, offer $75=½100+½ 50. However, at this price, only lemons are brought to the market. But buyers know that if they offer $75 only lemons are brought to the market. Then they will offer $50. Only lemons come to the market.

Information Problems Adverse Selection: Insurance Two types of people: healthy & sick ( ½ of each type). Healthy people have a 1/10 chance of becoming sick next year and sick people have a 9/10 chance of becoming sick. Suppose that an insurance agency charges $5 for $10 dollars worth of insurance. With this price the insurance company would break even if everybody is insured. (if the population is 20 people, the insurance company will have to pay on average to 1 healthy type individual and to 9 sick type individuals 10*10=100=5*20). However, if the insurance company charges this price only sick individuals will become insured. What price will the insurance company charge?

Information Problems Moral Hazard Insurance People change ACTIONS when being insured. They tend to take more risks. How much risk individuals take is unobservable. Insurance companies will increases rates. Consumers would prefer to pay a lower rate and take less risk. However, as actions are unobservable this is not feasible. Free Riding

Example Two people go to a restaurant and are deciding whether to order chicken (price=$5) or steak (price=$10). Suppose both of them value the steak $9 and the chicken $6. If they go by themselves they would both have the chicken. If they go together and they split the check they would both order the steak. If you order steak, the difference in cost for YOU is $2.5 ([$10-$5]/2). But you value the steak $3 more than the chicken. The increase in value is higher than the PRIVATE cost. Both of them will reason in this way and they will both order the steak.