Chapter 10 Asymmetric Information and Agency. Overview of Information issue Asymmetric Information Application of the Lemons Principle Consumer information, prices, and quality. Overview of Information issue. Prefect Information VS imperfect information Adverse selection in insurance market
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Overview of Information issue
Application of the Lemons Principle
Consumer information, prices, and quality
Example (10-1): used cars available for sale vary in quality. Information asymmetry arises if the sellers know better the true quality of their cars than do the potential buyers. Suppose that nine cars are to be sold given by their quality from 0 (lemon) to 2(mint). Assume the potential buyers know only the distribution of quality. It is known that the reserve value to the seller=1000*Q and buyer’s value=1500*Q
Step 1, if initial price=2000, all sellers agree to sell their cars. However, buyer do not know the quality of individual car, but they make a best guess the quality of 1 (average quality). Thus, buyers are willing to pay 1500
=> No deal
Step 2: if auctioneer sets the price=1500. Unfortunately, two sellers of best cars will quit the market. Now the remaining highest quality level of 3/2, and the average quality will be ¾. Potential buyer will pay only 1500*3/4=1125 for any cars.=> No dealRepeat the steps=> The lemon principle: the bad one drivers out the good until no market is left (Adverse Selection).
Suppose that both owners and no-owners in previous example were uncertain of the quality but only the average quality of products.
In step1, if price=2000=> no deal
In step2, if auctioneer set price=1500, the owners are willing to sell nine cares because their reserve price=1000*1(average quality)
The economic idea is that reduced information tends to give each firm some additional monopoly power.