Terms in this set (18)
Everyone is equally knowledgeable or equally ignorant about prices, product quality, and other factors relevant to a transaction.
One party to a transaction has relevant information that another party lacks.
2 types of asymmetric information
Hidden characteristics - an attribute of a person or thing that is known to one party but unknown to others.
Hidden actions - an act by one party to a transaction that is not observed by the other party.
one party takes economic advantage of another when circumstances permit.
Such behavior due to asymmetric information leads to market failures, and destroys many desirable properties of competitive markets.
2 Problems due to Asymmetric Information
Adverse Selection, Moral Hazard
occurs when one party to a transaction possesses information about a hidden characteristic that is unknown to other parties and takes economic advantage of this information.
One of the most important problems associated with adverse selection is that consumers may not make purchases to avoid being exploited by better-informed sellers.
As a result, not all desirable transactions occur, and potential consumer and producer surplus is lost.
an informed party takes an action that the other party cannot observe and that harms the less-informed party.
Insurance Markets - Adverse Selection
Were a health insurance company to provide fair insurance by charging everyone a rate for insurance equal to the average cost of health care for the entire population, the company would lose money due to adverse selection.
Adverse selection results in an inefficient market outcome because the sum of producer and consumer surplus is not maximized.
The loss of potential surplus occurs because some potentially beneficial sales of insurance to relatively healthy individuals do not occur.
Products of Unknown Quality
Adverse selection often arises because sellers of a product have better information about the product's quality—a hidden characteristic—than do buyers.
If buyers have the same information as sellers, no adverse selection problem arises.
However, when sellers have more information than buyers, adverse selection may drive high-quality products out of the market.
Reducing Adverse Selection
1. Restrict the ability of the informed party to take advantage of hidden information.
2. Equalize information among the parties.
Health insurance markets have adverse selection because low-risk consumers do not buy insurance at prices that reflect the average risk.
Such adverse selection can be eliminated by providing insurance to everyone or by mandating that everyone buy insurance.
an action taken by an uninformed person to determine the information possessed by informed people.
an action taken by an informed person to send information to an uninformed person.
a metric or scale for evaluating the quality of a particular product.
report that a particular product meets or exceeds a given standard.
FEELE Lab Learning Outcomes
Asymmetric information leads to adverse selection in an insurance market.
It is not always good for the consumer to be better informed.
Characteristics of insurance markets in general.
Symmetric Info: Principal-Agent Problem
Moral hazard is not a problem if Paul lives in Miami and can directly supervise Amy.
They could agree to a contract that specifies Amy receives 200 per day if she works extra hard, but loses her job if she doesn't.
Amy bears no risk: She receives 200 regardless of demand conditions.
Paul is the residual claimant: He receives the residual profit, which is the amount left over from the store's profit after Amy's wage is paid.
This result is called perfect monitoring: this contract is efficient because Paul, the risk-neutral party, bears all the risk, and their combined earnings are as high as possible because Amy works extra hard.
Asymmetric Information - Principal Agent problem
Fixed-fee contract - one party pays the other a constant payment or fee.
Because Amy receives the same amount no matter how hard she works, Amy chooses not to work hard, which is a moral hazard problem.
The expected combined earnings are less than in the previous example with symmetric information.