Econ 101: Chapter 19 Flashcards
(40 cards)
Private information
when one party to a transaction knows something the other doesn’t
Asymmetric information
when two parties don’t have the same information.
In the scenario of buying a used car…
the sellers have private information.
When sellers have private information…
low quality goods will sell for higher than what they are worth, and high quality goods will sell for lower than what they are worth.
Sellers of high quality goods…
may not choose to sell, because they aren’t offered high enough prices.
Adverse selection of sellers
the tendency for the selection of goods to be skewed toward more low-quality goods when buyer’s can’t observe quality.
the risk of buying low quality goods…
reduces the price buyers will pay, causing high quality goods to exit the market.
Adverse selection death spiral (sellers)
the cycle of high quality goods exiting the market continues until only low quality goods are left.
risk neutral
indifferent to risk.
Adverse selection of sellers results in a…
market failure - people are unable to buy and sell high quality goods (inefficient outcome).
3 solutions to adverse selection of sellers
- buyers can learn from third party verifiers.
- sellers can signal their product’s quality.
- Government can increase information or weed out low-quality goods.
For a signal to work…
it must be substantially costlier for sellers of low-quality goods to send the signal than for sellers of high-quality goods to do so.
Signals are only reliable when…
sellers of high quality goods are much more likely to find it worthwhile to send the signal (price difference).
Adverse selection of sellers: government policies
government policy can reveal information to buyers, make it mandatory to reveal info, and keep low quality sellers out of the market.
in the scenario of health insurance…
the buyers have private information about their health.
when buyers have private information…
the low cost buyers are not likely to buy the product, and high cost buyers are likely to see it as a good deal.
low cost buyers are likely to…
not buy the product, as it is too expensive.
adverse selection of buyers
the tendency of the mix of buyers to be skewed toward more high-cost buyers when sellers don’t know buyers’ type.
adverse selection death spiral (buyers)
when insurance companies charge more, causing more low cost buyers to leave, until only high cost buyers are left.
Adverse selection of buyers results in…
a market failure - low cost buyers want to buy, but they can’t as insurance companies don’t know that they are a low cost buyer.
letting people opt back into insurance when they need it…
worsens adverse selection.
risk aversion
people who dislike risk and uncertainty.
risk averse buyers will…
still buy, even if they have private information that they will be lower cost on average.
3 solutions to adverse selection of buyers.
- sellers can use information that is related to buyer’s likely costs.
- Sellers can offer different contracts so that buyers separate themselves.
- Government can increase information or directly reduce adverse selection.
