CHAPTER 8 ADVERSE SELECTION:AKERLOF S MARKET FOR LEMONS
CHAPTER 8 ADVERSE SELECTION: AKERLOF’S MARKET FOR LEMONS
Intro A man walks into the office of a life insurance company. He wants to buy a s1 million life insurance policy for a term of one day.Your company will have to pay s1 million to his heirs if and only if he dies tomorrow. You know nothing else about this man. How much do you charge? Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Intro A man walks into the office of a life insurance company. He wants to buy a $1 million life insurance policy for a term of one day. Your company will have to pay $1 million to his heirs if and only if he dies tomorrow. You know nothing else about this man. How much do you charge?
Asymmetric information Definition:a situation in which agents in a potential economic transaction do not have the same information about the quality of the good being transacted A major theme of this course,and the source of many problems in health insurance markets Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Asymmetric information Definition: a situation in which agents in a potential economic transaction do not have the same information about the quality of the good being transacted A major theme of this course, and the source of many problems in health insurance markets
THE INTUITION BEHIND THE MARKET FOR LEMONS Ch 8Adverse Selection:Akerlof's Market for Lemons
Ch 8 | Adverse Selection: Akerlof’s Market for Lemons THE INTUITION BEHIND THE MARKET FOR LEMONS
First:symmetric information Imagine a well-functioning used car market Sellers advertise cars,and buyers can accurately assess the condition of each car for sale Some buyers will be willing to pay more for cars in good condition;others are happy to get a deal Symmetric information:buyers and sellers have symmetric info about car quality.This is crucial. Outcome:each car sells for a different price, depending on its quality Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics First: symmetric information Imagine a well-functioning used car market Sellers advertise cars, and buyers can accurately assess the condition of each car for sale Some buyers will be willing to pay more for cars in good condition; others are happy to get a deal Symmetric information: buyers and sellers have symmetric info about car quality. This is crucial. Outcome: each car sells for a different price, depending on its quality
First:symmetric information Pareto-improving transaction:a transaction that leaves all parties at least no worse off One goal of a market is to make sure all Pareto- improving transactions take place In the market we have described,there is nothing to stop all Pareto-improving transactions from taking place All the cars end up with the people who value them the most Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics First: symmetric information Pareto-improving transaction: a transaction that leaves all parties at least no worse off One goal of a market is to make sure all Paretoimproving transactions take place In the market we have described, there is nothing to stop all Pareto-improving transactions from taking place All the cars end up with the people who value them the most
Next:asymmetric information New assumption:sellers can determine car quality, but buyers cannot All cars look identically good to the buyers This market will look different from the previous one in several ways: any cars that sell,sell for the same price The best cars will not be offered on the market It is possible that the cars will not end up with the people who value them most(buyers) Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Next: asymmetric information New assumption: sellers can determine car quality, but buyers cannot All cars look identically good to the buyers This market will look different from the previous one in several ways: any cars that sell, sell for the same price The best cars will not be offered on the market It is possible that the cars will not end up with the people who value them most (buyers)
Why is there only one price? Imagine that two cars are offered for different prices in this market:P and P'>P No buyer will want to buy the expensive car, because both cars will seem the same All sellers will have to lower their prices to match the lowest price on the market Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Why is there only one price? Imagine that two cars are offered for different prices in this market: P and P’ > P No buyer will want to buy the expensive car, because both cars will seem the same All sellers will have to lower their prices to match the lowest price on the market
Why are some cars not offered? We know the market has one price P Consider the seller who owns the nicest car on the market-it is probably worth way more than P That seller has no reason to remain in the market Why doesn't he advertise the high quality of his vehicle and charge a higher price? Remember,buyers can't“see”quality Outcome:only the lower-quality cars stay on the market.This is our first example of adverse selection. Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Why are some cars not offered? We know the market has one price P Consider the seller who owns the nicest car on the market – it is probably worth way more than P That seller has no reason to remain in the market Why doesn’t he advertise the high quality of his vehicle and charge a higher price? ◼ Remember, buyers can’t “ see ” quality Outcome: only the lower-quality cars stay on the market. This is our first example of adverse selection
Adverse selection Definition:the oversupply of low-quality goods,products,or contracts that results when there is asymmetric information. This is one of the most important ideas in health economics. Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Adverse selection Definition: the oversupply of low-quality goods, products, or contracts that results when there is asymmetric information. This is one of the most important ideas in health economics