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.
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.
Game Rules • Form a second-hand market for cars. • Class will be divided into 2 sides: • Used-car owners • Car buyers (dealers)
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.
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.
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.
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.
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
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.
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?
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?