eaton micro 6e ch20

7/27/2019 Eaton Micro 6e Ch20

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© 2005 Pearson Education Canada Inc.20.1

Chapter 20

Asymmetric Information and

Market Behaviour




Asymmetric Information

This Chapter examines cases of asymmetric (differing) information inmarket exchanges.

The goal is to predict how exchangeswill be organized to best manage thesubsequent transaction cost problems

that arise when buyers and sellers havedifferent information.




Figure 20.1 Incentives to produce low quality




Figure 20.2 Incentives to produce high quality




Sunk Costs

An interesting feature of the role of reputations is that they involve sunkassets (costs).

It is the actual commitment of a realresource that demonstrates goodwill.

With asymmetric information, the fact thatsunk costs do not affect the level of outputmakes them the optimal method of developing a reputation.




The Hold-Up Problem

Whenever there is a large sunkinvestment involved in an exchange,there is the threat of a hold-up

problem ( customers or suppliersattempting to appropriate rents).




Vertical Integration and Long-Term

Contracts

Two general solutions to the holdup problem are:

1. Vertical integration-a firm buyinganother firm that supplies its inputsor markets its outputs.

2. Long-term contracts-where firmscontractually agree to a price forthe entire life of the relationship.




Adverse Selection

Adverse selection occurs when two partieshave 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 forhealth insurance than are healthy people,but this characteristic may be hidden fromthe insurer.




Hidden Characteristics

Three assumptions are made in theanalysis of the insurance industry:

1. The probability of loss from a collision is

not uniform across drivers.2. Each driver is completely informed about

his/her own characteristics.

3. The driving characteristics of anindividual (high/low risk) are hiddenfrom the insurance company.




Full-Information Equilibrium

When identifying risk characteristics isprohibitively expensive, if all driversbuy insurance, low-risk drivers pay

more than the equilibrium and high-riskdrivers pay less.

Low-risk drivers subsidize insurance for

high-risk drivers.




Full-Information Equilibrium

If the proportion of high-risk drivers is nottoo high, then in equilibrium, all driversbuy 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-riskdrivers will buy insurance, and low-risk

drivers will be forced out of the market.




The Lemons Principle

Assume there are only two types of used cars, lemons and jewels andthat ascertaining whether a given car

is a lemon or a jewel is prohibitivelycostly.

All persons who want to sell their carput them on the market, so the priceof a used car reflects the mix of lemons and jewels for sale.





Some owners who want to sell their jewels at a “fair price” may decidenot to sell at the market price (which

includes lemons).As a result the proportion of lemons

on the market rises, furtherdepressing the market price andinducing other jewel owners towithdraw from the market.





If all jewel owners make this choice,there will a market for lemons butnot jewels.

Because of this hidden characteristic ,the jewels are driven out of themarket by the lemons (the lemon

principle).




Signalling

Adverse selection is not a hopelessproblem. Individuals who aredisadvantaged can respond by

signalling.Signalling is a way for low-risk

drivers to identify themselves toinsurance companies.

One way to signal is to have someform of low-risk certification.




Low Risk Certification

If the certificate is to produce an equilibrium,3 conditions must hold:

1. Insurance companies must be convinced the

certificate does signal low risk.2. The cost to low-risk drivers must be low

enough they have an incentive to acquire it.

3. The cost to high-risk drivers must be highenough they have no incentive acquire it.




Signalling Equilibrium

If it is very costly for high-riskdrivers to obtain the signal and nottoo costly for low-risk drivers, then

there will be a signalling equilibriumin which low-risk drivers acquire thesignal in order to differentiate

themselves from high-risk driversand obtain a lower insurance rate.




Moral Hazard Problems: Hidden Action

Moral hazard comes from the insuranceindustry, where the probability of anaccident increased when it was insured.

People are less careful when they areinsured for loss.





Suppose all drivers are identical and havethe same probabilistic loss (L).

If the driver spends some amount (C) onaccident prevention, the probabilistic lossof L is reduced from q to q’.

The problem is that spending on C cannotbe observed by insurance companies (itis hidden).





If all individuals could credibly promise tospend C on accident prevention, the priceof full coverage would be q’L and he/she

would be better off.

But, since the action is hidden, thepromise is not credible , and the

insurance companies will not offerinsurance at this price.




Deductibles

One way for the insurance company tosolve this moral hazard problem isthrough the use of deductibles.

Deductible means that the insuredindividual must pay some fraction of thecost of the accident.

This effectively prevents the person from

having full insurance and people arewilling to bear some costs (being morecareful) to avoid having to pay thedeductible.

eaton micro 6e ch20

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