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Microeconomics 2

Microeconomics 2. John Hey. Asymmetric Information. The seller of the good knows more about its quality than the buyer.. Perhaps the market does not exist … …or is inefficient. Perhaps sellers need to signal the quality. Perhaps that is why you are at university? This lecture examines:

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Microeconomics 2

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  1. Microeconomics 2 John Hey

  2. Asymmetric Information • The seller of the good knows more about its quality than the buyer.. • Perhaps the market does not exist … • …or is inefficient. • Perhaps sellers need to signal the quality. • Perhaps that is why you are at university? • This lecture examines: • the market for lemons; • moral hazard; • adverse selection; • signalling and reputation.

  3. A simple example: the market for used cars • Two types: lemons and plums (each 50%). • Suppose that buyers cannot tell the difference. • Reservation prices: • Seller of a plum: 2000 • Seller of a lemon: 1000 • Buyer of a plum (recognised as such): 2400 • Buyer of a lemon (recognised as such): 1200. • What will happen if a buyer cannot can tell whether a car for sale is a plum or a lemon? • (In the book I use different numbers but the argument is the same.)

  4. A more complicated market • Where there is a continuum of quality. • Supply increases with the price, as does the quality. • There are two effects of the price on demand: the usual – an increase in the price causes a fall in demand; and an indirect effect through the rising quality pushing up the demand for the good. • Let us go to Maple...

  5. Insurance market • If the insurance company knows the probability of an accident… • …there is not a problem. • But the existence of insurance changes the probability (moral hazard)– or the insurance company does not know the probability (adverse selection) – there is a problem. • It may be possible to solve this second problem with a separating equilibrium.

  6. Other methods • Guarantees • Reputation. • Experience. • Signals. • Usually we have to have repetitions, • Note the high prices and low quality in tourists markets.

  7. Signaling • Two kinds of workers: unable (1) and able (2) with marginal productivities a1and a2. (a1<a2). Propn. b able. • If distinguishable, firm pays a1 to unable and a2 to able. • If not distinguishable, firm offers wage (1-b)a1+b a2. OK? • Consider education e1and e2 with costs c1e1and c2e2 . • Suppose c2<c1 – it is less costly/easier for the able. *** • Suppose e* is such that • (a2-a1)/c1 < e* < (a2-a1)/c2 (which must be possible) • Firm pays a2 to those with education e*, and a1 to those with education 0. • The unable choose e=0; the able choose e=e*. (Why?) • Is this an equilibrium? Is this why you are at University?

  8. Why are you here? • …to learn? • …to have fun? • …to avoid serious work (for the moment)? • ...because you do not know what you want out of life? • …to get a signal (your degree, your mark) of your quality? • To be useful such a signal must be informative: the higher the mark the better the student. • That is why I examine this module the way that I do. • My exams are not tests of memory ... • ... they are tests of ability/understanding.

  9. Lecture 34 • Goodbye!

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