L14 - Asymmetric Information - Adverse Selection

Question 1

What is the Adverse Selection Model under a monopoly?

Answer 1

Question 2

What is the outcome of the Adverse Selection simple model with Full Information?

Answer 2

Given that:

• P = 𝜃 if s = 1 and the consumer would buy, x =B
• P=0 if s=0 and the consumer would buy, x = B

In terms of welfare across the two possible quantities we can state:

• Expected consumer surplus is 0, E(CS) = z(𝜃-p) + (1-z)(0-p) = 0
• Expected Profit equal, E(π) = z(p - c_H) + (1-z)(p-c_L) = z(𝜃-C_H) > 0
• Expected total welfare equals, E(W) = z(𝜃 -c_H) > 0

Question 3

What is the outcome of the Adverse Selection simple model with Asymmetric Information?

Answer 3

• Now we will assume the product quality is private information to the monopolist. In which case, the good is an experience good - consumers can only evaluate utility post-consumption.
• A classic example of experience goods in terms of adverse selection where quality is exogenous is used or second-hand cars
• We are assuming rationality –> the monopolist will only be willing to sell if he has a low product (even if he hasn’t)

Question 4

What level of trade would occur in the market if:

i) zθ < c_L
ii) zθ > c_H

Answer 4

1. market would break down as there would be no trade of boh high-quality products, and low-quality product
2. trade would occur, as expected willingness to pay is higher than the marginal cost of the higher cost product
   
   1. on average they are happy to trade

Question 5

What is the adverse selection model with continuous quality?

Answer 5

• unit mass –> tiny individual consumers (the amount of them thus will not effect our result)

Question 6

Notes of Uniform distribution?

Answer 6

Question 7

What is the equilibrium to the adverse selection model with continuous quality?

Answer 7

• until only the lowest quality suppliers can trade, at zero price
  *

Question 8

Wider Applications of Adverse Selection?

Answer 8

• Insurance
  
  • People are better informed than insurers about how healthy they are. Less healthy people are more likely to demand insurance, driving the price of insurance up. Healthy people find it too expensive and drop out, further increasing the price, and potentially destroying the market
• Credit
  
  • – people are better informed than lenders about how credit worthy they are… (Flesh this out with notes from last year)
    
    • ​if rates are high the ones that want to seek out loans are those that are less creditworthy –> creditors realise this and raise rates to account for these risks and cost that price out more creditworthy borrowers –> leaving you with the worst borrowers and evaporating the market
      Labour
  • – potential employees are better informed than employers about how productive they are…Less productive people drive down the wage rate. Productive people may find it optimal to leave the market, further reducing the wage, and potentially destroying the market.
• Migration
  
  • – potential migrants are better informed than governments about their potential to commit terrorism…The possibility of a even a tiny few potential terrorists amongst migrants may prompt governments to have strict border controls, and potentially destroy the possibility of valid beneficial migration.

Question 9

Lehn (1984, Econ Inquiry)

Answer 9

• Those that resigned had a lower risk of injury –> had private information on players and kept the healthier ones and sold the ones more injury prone

Question 10

Emons and Sheldon (2009)

Answer 10

• All cars made in 1985 registered in Basle (Swi) 1985-91. The researchers use data from mandatory safety checks as a measure of quality.
  
  • i) high quality cars are less likely to be sold shortly after purchase.
  • ii) probability of selling car in given period decreases with ownership duration
  • iii) (privately) sold cars have lower quality than average
• These findings are consistent with buyers having initial quality uncertainty, learning attributes soon after purchase, and keeping hold of higher quality cars, while selling low quality cars.
  
  • iv) cars sold by dealers have above average quality
• Evidence of how dealers maybe escape asym info problems through repeated interaction or signalling?