## Asymmetric Information

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When one party of a transaction has more or better information than the other party

When sellers have more information than the buyers —> surplus-generating trades may not occur —> this is the market value

Could be transaction that would make both sides better, but asymmetric info prevents it from happening, as we will explain

## Adverse selection

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hidden fixed characteristics at the time of contracting

Fixed in the sense that they don’t change but you hide it (I.e. they don’t know about some characteristic that you have when you make the transaction (but they may learn it))

Ex: insurance - people with hidden characteristics buy it - someone who knows that they are sick could buy it - they know it but other side doesn’t

Ex: other side doesn’t know things like how bad a driver you are, how likely you are to get sick, or how smart/hard-working you are when you engage in a transaction with them

## Moral hazard

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hidden actions following contracting

Ex: insurance - after you buy insurance, you behave recklessly (I.e. buy car insurance and then drive more reckless)

Stuff that happens after you buy it,. such as questions about your investment strategy after getting funding or how hard you will work after receiving a loan

## Lime/Lemon/Candy overview

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2 groups of people - group 1 (citrus farmer) has a brown paper bag which has either a lemon or a lime (they don’t know); group 2 (juice producer) group has a mini-candy. Equal number of limes and lemons

group with the fruit (group 1) values a lime at 60 cents, a lemon at 30 cents, and a mini-candy at 50 cents

Group with the candy (group 2) values a lime at 70 cents, lemon at 40, and mini-candy at 50

So, for everyone a lime is better than a lemon; juice producer (group 2) values lime and lemon more than citrus farmer does

## No-Info Case

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Here, neither side has information about what is inside the bag - don’t know if lime or lemon

So, need to calculate expected value from a trade to see if worth it

To the farmer (group 1), EV (bag) = .50(.60)+.50(.30) = .45

To the juice producer (group 2), EV (bag) = .50(.70) + .50(.40) = .55

So, since the group without the bag values the bag more than the group with the bag, there can be trade for the mini candy (at 50 cents). Group 1 (sellers) will receive 50-45 = 5 cents and the buyers will receive 55-50=5 cents profit too.

If there were money, rather than just the mini-candies, could be trade between 45 and 55 cents, as this is the ZOPA - where everyone could benefit from a trade

## Asymmetric Information Case

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Now, same case, but the group with the bag (group 1) can see if it is a lemon or a lime

If price is a mini-candy (50 cents) - Since group 1 values limes more than candy, they will only want to trade the lemon. Group 2 won’t pay 50 cents for the lemon - need to lower the price. Market will unravel as no sale of limes. But, exchange for lemons between 30 and 40 cents could still occur.

Lime won’t sell for 60 cents, as group 1 can’t prove it is a lime, could be lying. Juice producer won’t pay 60 cents for this when expected value is 55 cents. Need a guarantee (if knew everything, then lime between 60 and 70 cents and lemon between 30 and 40) or no info - asymmetric information leads to a market failure in lack of trade when there should be trade here

## Used Car argument overview

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Adverse selection - consider a used car model, where the seller knows more about the car than the buyer.

Consider the buyer - ask why he is selling the car? Quality is worse than the price he’ll sell at. Buyer never wants to buy!

## Akerlof Model Setup

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Two groups of people

M is the stuff that people buy besides cars

xi is the quality of car i

Group 1:

Owns n cars; total income Y1

Total utility = U1 = M + from i=1 to n, the sum of xi

This means utility is what they can buy besides cars + the sum of the qualities of the cars they buy. One unit of utility for 1 unit of quality of the car

Group 2:

Owns 0 cars, total income Y2

Total utility = U2 = M + the sum from i=1 to n, 3/2* xi

This is saying the utility is what they can buy besides cars + 1.5 utility units for 1 unit of quality of car they buy. 50% more utility per quality than group 1

## Group 1's cars

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n cars, think of n as large

Quality is uniformly distributed with values between 0 and 2

Price of M (Other uses of income besides cars) is 1; price of cars is p

Note: single price for all cars bc buyers can’t tell difference in quality

μ is the average quality of cars on market for sale

## Group 1 D&S

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If μ > p —> D1 = Y1/p

If the quality is greater than the price, then they spend all their money on cars

If μ

D1 = 0

If quality is less than price, then spend no money on cars, all on the other stuff

Average quality of cars on the market:

Start with recognizing that the quality of cars is uniformly distributed between 0 and 2. Imagine a number line with this distribution

Then realize that there is a price p between 0 and 2 - only car quality between 0 and p will come onto the market

So, the average quality will be the midway point between 0 and p = p/2 (note this 2 is different from the 2 being the upper range, but rather is showing it is the midway point between 0 and p)

So, average quality of cars on the market = μ = p/2

Supply of cars of group 1

They will supply cars with quality between 0 and p —> fraction of cars supplied will be the ones between 0 and p divided by the total number of cars (2). So, supply of cars = (p-0)/(2-0) = p/2.

This is the fraction of cars supplied - need to multiple this by n to get the total number of cars

This depends that the upper range of quality of cars on the market is 2

So, total supply of cars of group 1 —> If p≤2, then S1 = p*n/2