Chapter 15 Imperfect Information in the Product Market

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Chapter 15Imperfect Information in the Product
Market
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Learning Goals

• In this chapter we will learn
• About the critical ways information affects
  markets
• What the adverse selection problem is, and how it
  affects markets
• What the incentive problem is, and how it affects
  markets
• How search is explained by imperfect information

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Why do we care about imperfect information?

• Real world do not match the model of perfect
  competition.
• Specifically , the assumption of perfect
  information
• Market participants are fully informed about the
  good bought and sold
• Problems

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The Market for Lemons and Adverse Selection

• Why a 3 month old car sell for much less than a
  new car?
• George Akerlof (UC Berkeley/ 2001 Nobel Prize
  recipient)
• Lemons driving high quality used cars out of the
  market
• How? Adverse Selection

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The Market for Lemons and Adverse Selection
QUALITY CURVE
SUPPLY CURVE
DEMAND CURVE
PRICE OF USED CARS
E
AVERAGE QUALITY OF USED CARS
PRICE OF USED CARS
QUANTITY OF USED CARS
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The Market for Lemons and Adverse Selection

• Asymmetric Information between sellers and
  buyers, one party has more information than the
  other.
• Other examples Startup companies, insurance
  buyers, manufacturers, etc.
• Thin markets, nonexistent markets.

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The Market for Lemons and Adverse Selection

• Signaling actions speak louder than words ? A
  signal is effective if it differentiates goods
• KIA 10 year-100,000 mile warranty, good for buyer
  
• Nice showrooms and expensive furniture
• The desire to convey information distorts
  decisions

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The Market for Lemons and Adverse Selection

• Screening Use observable information to make
  inferences about the private information.
• Insurance companies using statistical data on
  accident rates to set premiums 19 year-old male
  vs. 40 year-old female.

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The Market for Lemons and Adverse Selection

• Judging quality by price.
• In markets with imperfect information, firms set
  their prices.
• Consumer inferences from price about quality
  impede the effectiveness of price competition.

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The Incentive Problem

• Provide incentives to motivate individuals to
  make the best choice is one of the central
  economic problems.
• The problem arises when individual do not bear
  the full consequences of their actions.
• For example, savings and loans associations with
  federally insured funds.
• The misalignment of incentives is called Moral
  Hazard.

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The Incentive Problem

• Moral Hazard originated in the insurance
  industry.
• Individuals insured for more than 100 percent of
  the loss would have an incentive to make it
  happen.
• Fire insurance and sprinkler systems.
• In competitive model, prices and private property
  provide incentives.
• Incentive problems arise when individuals are not
  rewarded for what they do or they do not have to
  pay the full cost for what they do.

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The Incentive Problem

• Market Solutions
• Agreements with built-in incentives (prizes and
  penalties)
• Complicated transactions, more difficult to solve
  the incentive problem
• Who will mown your lawn? Who owns the mower?
• Private property and prices

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The Incentive Problem

• Contract Solutions
• Sign a contract which specifies the conditions of
  the transactions.
• Escape clauses and contingency clauses.
• BUT, no one can think of every contingency. Even
  if someone can do it, it will be very expensive.
• Contracts are incomplete and expensive to enforce.

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The Incentive Problem

• Reputation Solutions
• Reputation is a form of guarantee.
• Desire to maintain a good reputation is what
  provides the incentives.
• To be effective, it should affect the profits.
• Competitive markets with perfect information,
  PMC.
• In markets with reputation mechanism, PMC
• Reputation can act as a barrier to entry

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The Market for Health Insurance

• Around 45 million of Americans are without health
  insurance. Those who have health insurance are
  sometimes dissatisfied with the coverage.
• Health insurance market is plagued with problems
  that arise from imperfect information
• Moral Hazard (Consumers)
• Adverse Selection (Insurers)
• HMOs and Health Savings Accounts

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The Search Problem

• Questions What goods are available on the
  market, at what price, and where? Job
  opportunities? Demand curves and input prices?
• With perfect information, finding all the prices
  is costless.
• Price dispersion? In a world of costly
  information, high price sellers still able to
  keep some customers (and make profits)

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The Search Problem

• With price dispersion and quality variations,
  households and firms spend energy searching.
• Process by which information is gathered is
  called search.
• Since search is costly, it stops before you have
  all the relevant information.
• Internet search
• Expected marginal benefits and marginal costs of
  searching.
• Expected marginal benefits increase with price
  and quality dispersion.