Asymmetric Information Flashcards
(37 cards)
Why can information be a potential source of market failure?
consumers and firms may not know or be fully informed of the opportunities or costs associated with their decision-making.
What is asymmetric information?
Where some agents hold more/better information than others. It doesn’t always cause market failure without government action but can complicate the operation of real-world markets - firms/consumers will have to take action to prevent complication
How is information asymmetry within a market important?
- One side of a transaction knows more about themselves, but the other side does not - this can lead to the problem of adverse selection, choice made may be poor.
- One side can take actions that the other side cannot observe - this can lead to the problem of moral hazard.
What happens if it is costly to gain accurate information?
If important information is costly to obtain then it is no longer possible to that buyer and seller to have the same info.
The cost of information provides an important source of market friction and therefore something we need to consider when analysing any market.
What is a classic example for looking at the illustration of hidden/private information?
the used car markets is important - this was developed by Akerloff (1970).
A typical car buyer will not be able to tell the difference between:
- lemons - low quality used cars
- peaches - high quality used cars
What is the problem of hidden/private information?
It is advantageous for the seller of a lemon to pretend it is a peach (as they are worth more) - seller knows the true quality.
Since the buyer cannot tell the difference between a lemon and a peach they will not be willing to pay more then what the average quality car is worth.
What happens in the market for lemons when buyers make a offer?
if we assume there is a equal number of lemons and peaches - a peach is worth £10,000 a lemon is worth £5000.
E(V) = 1/2 (10,000) + 1/2 (5000) = £7500. Buyer will offer £7500 and no more, since the buyer cannot tell the difference between a lemon and a peach they will not be willing to pay more than the expected value of the average quality car is worth.
Since the buyer is only paying their expected value, it is below that for peaches, so the seller of peaches leaves the market.
What happens when the highest quality car (peaches) exits the market?
The average quality of car fall - buyers respond by lowering the price they are willing to pay - so the best cars currently available again to leave the market. But same problem just happens again and again.
At the end of the ‘death spiral’ the market collapses and buyers either buy a lemon or concluded that they don’t want to buy any used car that is offered for sale.
What is Gresham’s law and how is it linked to the lemons problem?
Because the bad car have drive the good cars out of the market -named after Sir Thomas Gresham, bad coins would drive out those that were goods.
What is adverse selection?
This is the idea that ex-ante i.e. before purchase the buyer cannot distinguish between the quality of competing goods.
The notion of adverse selection is simple and yet there are many applications in the real world.
What are examples of adverse selection in the real world?
- consumer durables (high quality/low quality)
- service providers (who provides good/bad service) - domestic services e.g. gas installers, plumbers. personal services e.g. medical or legal services
- financial markets - insurance (who is safe risk/bad risk), bank lending (who will default)
- employment - hiring workers (who’s most productive)
Why can adverse selection be addressed?
sectors like the used car market is thriving which tells us that there are effective ways of addressing the problem of adverse selection - inspection, vehicle history, report, warranties, certified, pre-owned programmes
What are the solutions that can better support the markets of adverse selection?
- actions taken by the seller - signalling the best informed party to take actions to reveal their unobservable true characteristics
- actions taken by a third party - appraisal
- action taken by the buyer - screening = the less informed party takes actions to learn about the true characteristics of the other side of the market.
What should higher quality sellers do?
may need to signal their true worth signals are observable actions taken by economic agents to convince others as to their true characteristics and hence value/quality.
Signals are everywhere and in many ways a key part of like
What are the different types of signals?
Guarantees/warranties reduce the risk of purchase, signalling that this is a high quality product as this is unlikely to happen as this is expensive for the company to do if the product were low quality.
Brand names relate to reputation of quality e.g. Coco Cola, a certain brand name have a high reputation and so consumers will always go back to them.
Licensing e.g. gas safe installers (ensure engineers have the right qualifications to carry out the work correctly), kite marks
Are all signals clear and how can they be important?
There is not always a clear distinction between a pure signal and firm looking to differentiate its products.
Signalling can solve the lemons problem but only if the cost of attaining the signal significantly differs between sellers.
Michael Spence (2011 Noble Peace Prize in economics) suggested that education could act as a signal in the job market.
With asymmetric info, employees cannot tell the difference between high productivity and low productivity workers,, they wont know how smart or skilled an applicant is.
How does a lemon problem occur in the job market?
average wage offered will be the low for high productivity workers and to high for lower productivity workers.
Higher productivity workers will be driven out the market - firm cannot get the best possible employees.
In the extreme only low productivity workers are hired
What 2 roles does education have?
- Improves human capital (knowledge enhancing)
- Acts as a signal of higher productivity (spence)
Firms can’t observe productivity levels of a worker before hiring them, but they can observe educational attainment which is regarded as a signal of higher productivity. Firms offer higher wages to workers with a given level of educational attainment and a lower wage to those who have not.
A degree provides a credible signal of useful skills and abilities and hence gives employers more info they can use in the hiring
What is in the interest of all workers?
To attain higher level of education to secure the higher wage. But education is costly, time, effort, stress etc, if education is to operate as an effective signal then the cost to attain the signal mist be sufficient to differentiate between different groups of workers
What should workers choose?
workers should choose the level of education at which the difference between their returns from education (wages) and their total educational cost is maximised (MB=MC).
Getting a degree is harder i.e. more costly for someone with lower ability and is less determined.
What is a pooling equilibrium in a educational context?
If the cost of attaining a given level of educational qualification is too high (relative to rewards) then no one will undertake education.
If the cost of attaining a given level of education qualification are too low then all workers will undertake education.
If education doesn’t actually improve productivity levels sufficiently then the education process would be socially inefficient (wasteful).
If either of the above situations occur then a pooling equilibrium exists and all workers will be paid the same wage - lemons problem.
What is the separating equilibrium in a educational context?
Spence suggested that high productivity individuals might find it less costly to undertake education.
If the cost of attaining the level of education is too high for low productive workers then they will refrain from undertaking education and if the cost of attaining the level of education is low enough to induce high productivity workers to undertake education, then a separating equilibrium exists (which solves the lemons problem)
High productivity workers will be paid high wages
Low productivity workers will be paid low wages
Are signals good?
They can solve the lemons problem created by asymmetric information, but signals are costly. It might be wasteful (relative to opportunity cost) to spend 4 years at university.
While many will learn useful skills/knowledge, some may prefer to simply learn more while working as opposed to spending time jumping through assessment hoops.
While signals do create inefficiently, they all generate benefits by creating more information - the individuals in market realise gains from transactions by overcoming problems of asymmetric information.
Effective signals don’t have to be complicated or involved - advertising and price can both be signals in certain cases. Good types are based on the ease with which consumers can evaluate quality.
What are the different types of goods?
- search goods = can be evaluated prior to purchase or consumption e.g. clothing, furnishings
- experience goods = can be accurately evaluated only after the product has been purchased and experienced e.g. restaurants, hairdressers, movies, holidays
- credence goods = difficult or impossible to evaluate even after consumption has occurred e.g. accounting, legal services, medical diagnosis
