© 2009 Pearson Education Canada 20/1 Chapter 20 Asymmetric Information and Market Behaviour

© 2009 Pearson Education Canada 20/2 Asymmetric Information  This Chapter examines cases of asymmetric (differing) information in market exchanges.  The goal is to predict how exchanges will be organized to best manage the subsequent transaction cost problems that arise when buyers and sellers have different information.

© 2009 Pearson Education Canada 20/3 Figure 20.1 Incentives to produce low quality

© 2009 Pearson Education Canada 20/4 Figure 20.2 Incentives to produce high quality

© 2009 Pearson Education Canada 20/5 Sunk Costs  An interesting feature of the role of reputations is that they involve sunk assets (costs).  It is the actual commitment of a real resource that demonstrates goodwill.  With asymmetric information, the fact that sunk costs do not affect the level of output makes them the optimal method of developing a reputation.

© 2009 Pearson Education Canada 20/6 The Hold-Up Problem  Whenever there is a large sunk cost (investment) involved in an exchange, there is the threat of a (customers or suppliers attempting to appropriate rents).  Whenever there is a large sunk cost (investment) involved in an exchange, there is the threat of a hold-up problem (customers or suppliers attempting to appropriate rents).

© 2009 Pearson Education Canada 20/7 Vertical Integration and Long-Term Contracts  Two general solutions to the hold up problem are: 1. firm buying another firm that supplies its inputs or markets its outputs. 1. Vertical integration - a firm buying another firm that supplies its inputs or markets its outputs. 2. Long-term contracts-where firms contractually agree to a price for the entire life of the relationship.

© 2009 Pearson Education Canada 20/8 Adverse Selection  Adverse selection occurs when two parties have different information. –For example, the selection of people who purchase insurance is biased in favour of those who need it the most.  Sick people are more likely to apply for health insurance than are healthy people, but this characteristic may be hidden from the insurer.

© 2009 Pearson Education Canada 20/9 Hidden Characteristics  Three assumptions are made in the analysis of the insurance industry: 1. The probability of loss from a collision is not uniform across drivers. 2. Each driver is completely informed about his/her own characteristics. 3. The driving characteristics of an individual (high/low risk) are hidden from the insurance company.

© 2009 Pearson Education Canada 20/10 Full-Information Equilibrium  When identifying risk characteristics is prohibitively expensive, if all drivers buy insurance, low-risk drivers pay more than the equilibrium and high-risk drivers pay less.  Low-risk drivers subsidize insurance for high-risk drivers.

© 2009 Pearson Education Canada 20/11 Full-Information Equilibrium  If the proportion of high-risk drivers is not too high, then in equilibrium, all drivers buy insurance and the low risk drivers subsidize the high risk drivers.  If the proportion of high-risk drivers is too large, then in equilibrium, only high-risk drivers will buy insurance, and low-risk drivers will be forced out of the market.

© 2009 Pearson Education Canada 20/12 The Lemons Principle  Assume there are only two types of used cars, lemons and jewels, and that ascertaining whether a given car is a lemon or a jewel is prohibitively costly.  All persons who want to sell their cars put them on the market, so the price of a used car reflects the mix of lemons and jewels for sale.

© 2009 Pearson Education Canada 20/13 The Lemons Principle  Some owners who want to sell their jewels at a “fair price” may decide not to sell at the market price (which includes lemons).  As a result the proportion of lemons on the market rises, further depressing the market price, and inducing other jewel owners to withdraw from the market.

© 2009 Pearson Education Canada 20/14 The Lemons Principle  If all jewel owners make this choice, there will a market for lemons but not jewels.  Because of this hidden characteristic, the jewels are driven out of the market by the lemons (the lemon principle).

© 2009 Pearson Education Canada 20/15 Signalling  Adverse selection is not a hopeless problem. Individuals who are disadvantaged can respond by signalling.  Signalling is a way for low-risk drivers to identify themselves to insurance companies.  One way to signal is to have some form of low-risk certification.

© 2009 Pearson Education Canada 20/16 Low Risk Certification  If the certificate is to produce an equilibrium, 3 conditions must hold: 1. Insurance companies must be convinced the certificate does signal low risk. 2. The cost to low-risk drivers must be low enough so they have an incentive to acquire it. 3. The cost to high-risk drivers must be high enough so they have no incentive to acquire it.

© 2009 Pearson Education Canada 20/17 Signalling Equilibrium  If it is very costly for high-risk drivers to obtain the signal and not too costly for low-risk drivers, then there will be a signalling equilibrium in which low-risk drivers acquire the signal in order to differentiate themselves from high-risk drivers and obtain a lower insurance rate.

© 2009 Pearson Education Canada 20/18 Moral Hazard Problems: Hidden Action  Moral hazard comes from the insurance industry, where the probability of an accident increased when it was insured.  People are less careful when they are insured for loss.

© 2009 Pearson Education Canada 20/19 Moral Hazard Problems: Hidden Action  Suppose all drivers are identical and have the same probabilistic loss (L).  If the driver spends some amount (C) on accident prevention, the probabilistic loss of L is reduced from q to q’.  The problem is that spending on C cannot be observed by insurance companies (it is hidden).

© 2009 Pearson Education Canada 20/20 Moral Hazard Problems: Hidden Action  If all individuals could credibly promise to spend C on accident prevention, the price of full coverage would be q’L and he/she would be better off.  But, since the action is hidden, the promise is not credible, and the insurance companies will not offer insurance at this price.

© 2009 Pearson Education Canada 20/21 Deductibles  One way for the insurance company to solve this moral hazard problem is through the use of deductibles.  Deductible means that the insured individual must pay some fraction of the cost of the accident.  This effectively prevents the person from having full insurance and people are willing to bear some costs (being more careful) to avoid having to pay the deductible.