Chapter 17 - Asymmetric information

Question 1

What is asymmetric information

Answer 1

We say we’re dealing with asymmetric ifnromation if some parties involved know more than others.

Question 2

Elaborate on the statement/questions “is this car/object a lemon?”

Answer 2

It refers to the question on whether the product is bad or not. Especially in the context of selling items that are relatively new. We ask, why would someone sell it? They might claim there is nothing wrong with it, but we, as the buyer, cant know for sure.

Question 3

Why do used cars, even if only slightly used, sell for so much less than OG price?

Answer 3

Because of asymmetric information.

Question 4

Define categories of goods in relation to asymmetric information

Answer 4

SEARCH GOODS: Goods for which the quality is basically known, so the potential buyer searches for the best price

EXPERIENCE GOODS: Goods where quality is only attainable through experience, that means AFTER purchase.

CREDENCE GOODS: Goods where it is difficult to understand the quality even with experience. Based fully on trust.

Question 5

Define and elaborate on the lemons problem

Answer 5

The lemons problem is that with asymmetric information, low-quality goods can drive high-quality goods out of the market.

Suppose 2 types of used cars are available. High quality and low quality. high quality cars will not experience faults. Low quality cars will, with experience, be subject to faults.

Suppose the seller ALWAYS know which type he is selling. However, the buyer does not know this. The seller always says it is high quality, i assume.

If seller and buyer know all information, then we would distinguish between them. We would set up one equilibrium for high quality, and another for low quality. Naturally, the price for the high quaity would be higher.
Let us say, in such a scenario, it is sold 50000 cars of each type. 10’000 bucks for high-quality, 5’000 bucks for low quality.

If buyers do not know the quality, what will he do? Well, consideirng the fact that with perfect informaiton, 50 000 cars of each type was sold. Therefore it is reasonable to think that it is a 50 50 chance. 5000USD0.5 + 100000.5 = 7500USD. This is the common case, as buyers rarely have access to the information necessary.

Now, because of the lower price, fewer high-quality cars will be sold. This is because the sellers would, in a larger degree than previously, be reluctant to give up the vehicle since they get less money than before. However, simultaneously, the opposite happens with the low quality cars. The sellers will think that the higher price than previously is a better deal, and will therefore increase the output. As a result, we would see a market of not 50 000 of each car being sold, but rather 25 000 high quality and 75 000 low quality.

Then we get the after-effects. Buyers will start recognizing that the majority of cars being sold is in fact low quality cars. Therefore, they will shift their demand to be more reluctant to pay much.

This cycle continue until there are only low quality cars in the market. In real life, there will always be some high quality cars, but they will be vastly outnumbered by low quality cars.

Question 6

Why is the lemons problem an example of market failure?

Answer 6

The result of the lemons problem is market failure because it cause a situation where the sellers of high-quality products loose their markets since the price becomes too low, while, at the same time, buyers of high-quality (who are actually willing to pay the high price) dont have a market to buy from.

So, sellers loose the market, and buyers loose the market. So, we miss the opportunity of having mutually beneficial trades.

Question 7

What is adverse selection ?

Answer 7

Adverse selection is a situation that arises when products of different qualities are being sold for the same price in the market as a result of imperfect information. As a result, we will get too much of the bad quality goods.

For instance, when insurance beomces prices based on the average risk, it will be an example of adverse selection.

Question 8

What are the possible solutions to the lemons problem for firms?

Answer 8

There are 2 broad ways:

1) Reputation
2) Standardization

Building a rep is important as it becomes a way of providing experience before the good is bought.

Standardization is a way of doing the same thing, but in a slightly different manner.

Question 9

Word association:

“Products of different qualities that are sold in a market for the same price”

Answer 9

Adverse selection

Adverse means: Hostile, harmful etc

Question 10

What is a “third” way of dealing with the problem of asymmetric information?

Answer 10

Market signaling.

Market signaling is the process of which sellers send signals to buyers conveying information about the quality of the product.

An example of a signal is education. In this case, the seller is the labor. The buyer is the firm. The firm needs to know if the worker is good or not. High or low quality. In order to help the firm, the worker needs to provide some signals indicating that he is of high quality.

Question 11

What is a good “signal”?

Answer 11

A good signal is one that is easy for high-quality products to give, while very difficult for low-quality products to emit.

Question 12

What’s a moral hazard in thisd context?

Answer 12

A moral hazard refers to after-contract behaviour that might damage one part of the party. It is exploition of terms. For instance, we might perform hidden actions after the contract is established.

Question 13

Define the principal-agent problem

Answer 13

When “agents” pursue their individual goals rather than the goals of their “principals”.

The problem comes from the fact that there is asymmetry in information between the principal and the agent. the agent knows more about his capacity and willingness to produce efficiently than the principal does.

Question 14

Elaborate on the principal-agent problem

Answer 14

When “agents” pursue their individual goals rather than the goals of their “principals”.

we consider a relationship where the agent acts while the principal is affected by these actions.

the main goal will be to implement strategies that align the goals of the agent with the goals of the principal.
The typical measure is to add reward structures to the firm, trying to flash money in the face of some agent in order to motivate him/her to follow the directives.

The main question becomes: how can principles create structures that merge the goals of the principal and the agents TOGETHER?

Question 15

What is the general “solution” to the principal-agent problem?

Answer 15

the general solution is to find a reward system that rewards good whenever effort is high, and rewards little when effort is low.

Question 16

What is the efficiency wage?

Answer 16

The efficiency wage is the wage level at which workers stop shirking and start being productive as a result of the case where they might get fired and not get another job that has the same pay.

Then one might wonder, what happens when all firms offer this wage? wouldnt that cause the same unwanted effect? THe answer is NO. This is because as the higher wage is given, the firm’s demand for labor decrease. Therefore, when this happens at all firms, there will be some unemployment in society.

So, it is basically a result of workers being difficult to monitor. Firms try to avoid workers slacking off at job. Therefore they offer a higher wage. But all firms do this, so this wage is normal. However, this also decrease demand for labor, which cause unemployment.

Question 17

mathematically, define the inequality that must be satisfied regarding max price payed for a new car (or any other object) in the lemons problem scenario

Answer 17

P <= (1-p)U_G + pU_B

Notice that this is basically just expected value.

This means: The price a buyer is willing to pay cannot be higher than the probability of getting a good car times the value of a good car PLUS the probability of getting a bad car times the value of a bad car.

It obviously follows that price P is going to be lower than U_G, the value of a new good car.

It is also reasonable to assume that the price will we higher than the user value of bad cars, but only slightly.

Question 18

Give the mathematical formula for disutility for working more hours than 40 in a week

Answer 18

C(e) =:

if e <= 40: 0 - infinitesmall

if e > 40: 1/2*(e-40)^2

In other words, the disutility of working 40 hours or less is infinitely small, meaning this is no problem.

If more than 40 hours however, we see a sharp increase in disutility.

Question 19

Elaborate on what will happen in regards to the principal-agent problem when the principal use fixed salary contracts

Answer 19

There will be no incentive for the agent to work more than the required amount of say 40 hours.

If the principal knows that each hour of work generate 100usd of net income, and that the paywage is at 1000 usd for 40 hours, profit is like this:

profit_principal = 100*40 - 1000 = 4k-1k = 3000 USD.

Profit_agent = 1000 - 0 = 1000 USD.

Question 20

Elaborate on what will happen in regards to the principal-agent problem when the principal use fixed salary + a bonus of say 10%. Consider fixed salary of 1000 usd per week. the principal nets 100 usd per hour.

Answer 20

The bonus becomes 10% * 100*AmountOfHours.

the agents profit is then:

pi = 1000 + 1000.1e - 1/2(e-40)^2

The last part is from the disutility (measured in monetary value) for extra work.

Finding the first order conditions:

∂pi/∂e = 10 - e + 40 = 0
e = 50

This means, the agent, under this specific bonus program and with his disutility of extra work, should work 50 hours, 10 hours more than he otherwise would.

If the agent work 50 hours, then what happens:

The firm earns a profit of: 100500.9 - 1000 = 3500 USD

the agent earns a profit of: 1000+100500.1-1/2(10)^2 = 1000+500-50 = 1450 USD

Therefore, both parties benefit from the bonus system.