ECON6021 (Nov 17amp;19).ppt

ECON6021 (Nov 1719) Information Asymmetry Informational economics When a person buys medical insurance, the insuring company does not know whether the person is healthy. Nor does it know how well he is going to take care of himself after buying insurance. The former type of asymmetry information is called a hidden type problem, or adverse selection problem. The latter type of asymmetric information is called a hidden action problem, or moral hazard problem. But the notion of moral hazard has subsequently expanded. Information economics is the study of decision makings between agents when their information is asymmetric. Adverse Selection Why called “Adverse Selection”? Adverse selection refers to a situation where a selection process (here market) results in a pool of products/individuals with economically undesirable characteristics. With “hidden type”, either (1) bad products drive out good products or (2) good products subsidize bad products (both receive the same price). Gresham’s law: bad money drives out good. Or, where two media of exchange come into circulation together the more valuable will tend to disappear. Adverse selection: Used Cars (Lemons) Market Scenario I: Full Information Suppose that every buyer and every seller know the type of the car they are negotiating. Then both good cars and bad cars will be traded. There are simply two products (good and bad cars). Scenario II: No Information Suppose buyers don’t know the type of the cars they are interested. Also suppose no sellers know the type of the cars they own. Assume all agents are risk neutral. Expected valuation of a car to buyers= 1/3 * $30K + 2/3 * $20K = $23.33K Expected valuation of a car to sellers = 1/3 * $25K + 2/3 * $10K = $15K Both good cars and bad cars will be traded! Scenario III: Asymmetric (Unequal) Information Sellers know the types of cars they own. But buyers don’t know the types of cars they are going to buy. Is a buyer willing to pay at a price greater than $25K (say $26K)?