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Adverse Selection & Market Failure Definition Asymmetric information occurs when traders of one side of the market know things that traders on the other side of the market do not . Adverse selection

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Adverse Selection & Market Failure

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Adverse Selection & Market Failure


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Definition

  • Asymmetric information

  • occurs when traders of one side of the market know things that traders on the other side of the market do not.

  • Adverse selection

  • a condition which occurs in a market when buyer or sellers would, on average, be better off trading with someone selected at random from the population than with those who volunteer to trade.


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Definition

  • Moral hazard

  • a condition which occurs when the actions taken by your trading partners are less favorable for you than the actions of the average member of the population.

  • Market failure

  • a condition which occurs when market cannot achieve an efficient allocation of resources.


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Game Rules

  • Form a second-hand market for cars.

  • Class will be divided into 2 sides:

  • Used-car owners

  • Car buyers (dealers)


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Instructions for used-car owners

  • You have a used car for sale.

  • If your car is still in good condition, then your reservation price* is $1200.

  • If your car is a lemon, i.e. a bad used-car, your reservation price is $0.

  • Only you know the condition of your used-car.


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Instructions for used-car owners

  • You can sell your car at any price. Once you have decided your price and written down on a paper, you cannot change it.

  • After the deal, you can give the buyer the small piece of paper which you got from the draw determining the condition of your car.

  • When your selling price is higher than your reservation price, the difference between them is your profit.


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Instructions for used-car buyers/ dealers

  • You want to buy used cars. You have $3000 to spend on buying cars.

  • You know that there are two types of used-cars in the market. They are either good used-cars or lemons, i.e. bad used-cars.

  • However, you have no idea what type of car a seller sells to you during the transaction. You will only discover the quality of the car shortly after you have bought it.


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Instructions for used-car buyers/ dealers

  • For a good used-car, you can resell it at $2500. For a lemon, you can only resell it at $500.

  • You can decide whose car you want to buy after knowing sellers’ selling prices.

  • After the deal, the car seller you approached will give you a small piece of paper indicating the condition of the car you have bought.

  • When your buying price is lower than the price at which you can resell the car, the difference is your profit.


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Game Rules

  • You have 2 minutes to think about your buying or selling price.

  • For used-car sellers, please write down:

  • Selling prices

  • The type of car you have, whether a good car or a lemon


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5 Minutes Trade

  • Now you have 5 minutes to trade.

  • Sellers can reveal your prices to buyers by putting up your price.

  • Buyers can approach sellers and decide whose car you want to buy. It is ok if you buy more than one car or you don’t buy any.


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Time’s Up!


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Discussion

  • Who have successfully sold your cars?

  • Is your car a lemon or a good one?

  • How did you set your price?

  • Did you tend to give wrong information to buyers?

  • Who could not sell your cars?

  • Can you explain why you couldn’t sell your car?


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Discussion

  • How many buyers bought their cars?

  • Did you make a profit or a loss from this transaction?

  • How did you make your decision when you were in the used-car market?

  • How many buyers could not buy their cars?

  • Why couldn’t you buy a car?

  • How can we solve the problem of asymmetric information in real world?


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