Chp.16 Asymmetric Information

How can these information institutions work to combat asymmetries in information?

Address the information asymmetry directly by allowing buyers to observe quality characteristics before a transaction takes place 2. Punish sellers who misrepresent their lemons as plums 3. Use incentives to increase the number of plums brought to market

Lemons Problem (3)

An asymmetric information problem that occurs when a seller knows more about the quality of the good he is selling than does the buyer. With asymmetric information, low-quality goods can drive high-quality goods out of the market. The lemons problem is that Pareto-improving market transactions fail to occur because of asymmetric information.

asymmetric information:

An imbalance of information across participants in a transaction a situation in which one party to an economic transaction has less information than the other party

A number of mechanisms have emerged to deal with adverse selection in insurance markets:

Group policies ‒ Tying insurance to employment removes the link between the individual's riskiness and the decision to purchase insurance. ‒ Pooling individuals reduces the effect of any given poor-risk person. Screening ‒ Detailed questionnaires, health exams, driving records, and so on Denying coverage

The Principal-Agent Relationship as a Game, list the stages:

In the first stage, the principal chooses from a set of contracts. • In the second stage, the agent chooses a level of effort resulting in payoffs to the principal and agent......The goal for the principal is to choose a contract structure that induces the agent to choose a high level of effort.

Examples of Increasing the Average Quality of Cars Placed on the Market:

Leasing can increase the average quality of used cars by encouraging return, regardless of quality.

Social Marginal Cost =

MC + EMC

How can you encourage employee to work hard instead of them shirking?

Rather than paying your employee a flat rate, you can instead pay employees a wage that varies with the profits of the job.....that way you make them indifferent to working hard or shirking

Examples of Incentives for Truthful Quality Reporting:

Reputation (e.g., online feedback) • Warranties and return policies (offered by seller).......Lemon laws mandate warranties and return policies for new and used vehicles in many states.

How might drivers' behavior change if they know they are covered by a comprehensive insurance policy?

The coverage may lead them not to try to prevent theft.

Examples of Reducing asymmetric information directly:

Third-party examinations of quality (e.g., mechanics) • Offering standardized, unbiased information products (e.g. Carfax)

market examples that have the Lemons problem:

Used merchandise sold online • Home improvement • Vehicle repairs • Labor • Insurance

principal-agent relationship

are a set of economic transactions that feature information asymmetry between a principal and his hired agent, whose actions the principal cannot fully observe. • Involves one party (the principal) hiring a second party (the agent) to perform a task and being unable to completely observe the effort of the agent The relationship between a principal and his or her agent. This relationship may be affected by the fact that each is motivated by self-interest, yet their interests may not be well aligned

moral hazard

arises when one party to a transaction cannot observe the other party's behavior. • When quality is difficult to observe, a party to a transaction may have a financial incentive to engage in fraud.

One major result of principal-agent problems is that good agents or products are not?

identifiable and therefore cannot command full value.

In what market would the buyer have more information than the seller? What information do the buyers have that sellers lack?

insurance Risk. Sellers are unable to determine quality, or the likelihood that a buyer will have claims.

signaling

is a solution to the problem of asymmetric information in which the knowledgeable party alerts the other party to an unobservable characteristic of the good. an action taken by an informed party to reveal private information to an uninformed party

To signal high quality credibly, a signal must be.....

less costly for high-quality agents than low-quality agents.

adverse selection:

market characteristics leading to more low-quality goods and fewer high-quality goods available

The lemons problem destroys economic value by? In response, what has happened?

preventing beneficial exchanges. institutions have developed to mitigate information asymmetries

To be a good indicator of quality, a signal must be?

relatively cheap for high-quality producers and expensive for low-quality producers.

Often, economic actors will attempt to communicate their quality via a ____________.

signal

Information asymmetries hurt who?

those with little information and also those with more information.

In insurance markets, adverse selection refers to the problem of deciding......

whom to insure and at what price.