You are on page 1of 21

Chapter 20 Asymmetric Information and Market Behaviour

20.1

2005 Pearson Education Canada Inc.

Asymmetric Information
This

Chapter examines cases of asymmetric (differing) information in market exchanges. The goal is to predict how exchanges will be organized to best manage the subsequent transaction cost problems that arise when buyers and sellers have different information.
20.2
2005 Pearson Education Canada Inc.

Figure 20.1 Incentives to produce low quality

20.3

2005 Pearson Education Canada Inc.

Figure 20.2 Incentives to produce high quality

20.4

2005 Pearson Education Canada Inc.

Sunk Costs
An interesting feature of the role of reputations is that they involve sunk assets (costs). It is the actual commitment of a real resource that demonstrates goodwill. With asymmetric information, the fact that sunk costs do not affect the level of output makes them the optimal method of developing a reputation.

20.5
2005 Pearson Education Canada Inc.

The Hold-Up Problem


Whenever

there is a large sunk investment involved in an exchange, there is the threat of a hold-up problem (customers or suppliers attempting to appropriate rents).

20.6

2005 Pearson Education Canada Inc.

Vertical Integration and Long-Term Contracts

1.

2.

Two general solutions to the hold up problem are: Vertical integration-a firm buying another firm that supplies its inputs or markets its outputs. Long-term contracts-where firms contractually agree to a price for the entire life of the relationship.
2005 Pearson Education Canada Inc.

20.7

Adverse Selection
Adverse selection occurs when two parties have different information. For example, the selection of people who purchase insurance is biased in favour of those who need it the most. Sick people are more likely to apply for health insurance than are healthy people, but this characteristic may be hidden from the insurer.

20.8
2005 Pearson Education Canada Inc.

Hidden Characteristics

1.

2.

3.

Three assumptions are made in the analysis of the insurance industry: The probability of loss from a collision is not uniform across drivers. Each driver is completely informed about his/her own characteristics. The driving characteristics of an individual (high/low risk) are hidden from the insurance company.
2005 Pearson Education Canada Inc.

20.9

Full-Information Equilibrium
When

identifying risk characteristics is prohibitively expensive, if all drivers buy insurance, low-risk drivers pay more than the equilibrium and high-risk drivers pay less. Low-risk drivers subsidize insurance for high-risk drivers.

20.10

2005 Pearson Education Canada Inc.

Full-Information Equilibrium
If the proportion of high-risk drivers is not too high, then in equilibrium, all drivers buy insurance and the low risk drivers subsidize the high risk drivers. If the proportion of high-risk drivers is too large, then in equilibrium, only high-risk drivers will buy insurance, and low-risk drivers will be forced out of the market.

20.11

2005 Pearson Education Canada Inc.

The Lemons Principle


Assume

there are only two types of used cars, lemons and jewels and that ascertaining whether a given car is a lemon or a jewel is prohibitively costly. All persons who want to sell their car put them on the market, so the price of a used car reflects the mix of lemons and jewels for sale.
20.12
2005 Pearson Education Canada Inc.

The Lemons Principle


Some

owners who want to sell their jewels at a fair price may decide not to sell at the market price (which includes lemons). As a result the proportion of lemons on the market rises, further depressing the market price and inducing other jewel owners to withdraw from the market.
20.13
2005 Pearson Education Canada Inc.

The Lemons Principle


If

all jewel owners make this choice, there will a market for lemons but not jewels. Because of this hidden characteristic, the jewels are driven out of the market by the lemons (the lemon principle).

20.14

2005 Pearson Education Canada Inc.

Signalling
Adverse

selection is not a hopeless problem. Individuals who are disadvantaged can respond by signalling. Signalling is a way for low-risk drivers to identify themselves to insurance companies. One way to signal is to have some form of low-risk certification.
20.15
2005 Pearson Education Canada Inc.

Low Risk Certification

1.

2.

3.

If the certificate is to produce an equilibrium, 3 conditions must hold: Insurance companies must be convinced the certificate does signal low risk. The cost to low-risk drivers must be low enough they have an incentive to acquire it. The cost to high-risk drivers must be high enough they have no incentive acquire it.

20.16

2005 Pearson Education Canada Inc.

Signalling Equilibrium
If

it is very costly for high-risk drivers to obtain the signal and not too costly for low-risk drivers, then there will be a signalling equilibrium in which low-risk drivers acquire the signal in order to differentiate themselves from high-risk drivers and obtain a lower insurance rate.
2005 Pearson Education Canada Inc.

20.17

Moral Hazard Problems: Hidden Action


Moral

hazard comes from the insurance industry, where the probability of an accident increased when it was insured. People are less careful when they are insured for loss.

20.18

2005 Pearson Education Canada Inc.

Moral Hazard Problems: Hidden Action


Suppose

all drivers are identical and have the same probabilistic loss (L). If the driver spends some amount (C) on accident prevention, the probabilistic loss of L is reduced from q to q. The problem is that spending on C cannot be observed by insurance companies (it is hidden).
20.19
2005 Pearson Education Canada Inc.

Moral Hazard Problems: Hidden Action


If

all individuals could credibly promise to spend C on accident prevention, the price of full coverage would be qL and he/she would be better off. But, since the action is hidden, the promise is not credible , and the insurance companies will not offer insurance at this price.
20.20
2005 Pearson Education Canada Inc.

Deductibles
One way for the insurance company to solve this moral hazard problem is through the use of deductibles. Deductible means that the insured individual must pay some fraction of the cost of the accident. This effectively prevents the person from having full insurance and people are willing to bear some costs (being more careful) to avoid having to pay the deductible.

20.21
2005 Pearson Education Canada Inc.