Chapter 9 Knowledge and Information

1. Chapter 9 Knowledge and Information In this chapter we want to see what happens in a market when the amount of information participants have is different across the participants.

2. markets vs. planning Say that Larry, Moe and Curly have the following demands for eggs: Quantity Larry Moe Curly 1 P = 15 P = 13 P = 7 2 P = 8 P = 11 P = 3 So the market demand curve is Q P 1 15 from Larry 2 13 from Moe 3 11 from Moe 4 8 from Larry 5 7 from Curly 6 3 from Curly

3. markets vs. planning Say firms A, B, and C have the following marginal cost or supply schedules for eggs: Quantity A B C 1 P = 1 P = 5 P = 6 2 P = 3 P = 11 P = 7 So the market supply curve is Q P 1 1 from A 2 3 from A 3 5 from B 4 6 from C 5 7 from C 6 11 from B

4. markets vs. planning So in the market we have P Qd Qs 15 1 13 2 11 3 6 And we see that Qd = Qs at a price 8 4 of $7. 7 5 5 6 4 5 3 3 6 2 1 1

5. markets vs. planning In the market setting where the price is $7, Larry buys two, Moe buys two, and Curly buys one and the total consumer surplus is 19. At the same time firm A sells two, firm B sells one, and firm C sells 2 and the total producer surplus is 13. The social gain from trade in the market is 32. Now let’s imagine we have a society where a social planner has to decide what output level to have. Let’s even imagine 5 units are produced and distributed in the following way.

6. markets vs. planning In the social planning experiment, Larry gets two, Moe gets one, and Curly gets two and the total consumer surplus is 11. At the same time firm A gets to make one, firm B gets to make two, and firm C gets to make two and the total producer surplus is 5. The social gain from this type of trade is 16. Unless the social planner knows for sure what each individual knows, then the social planner can not reproduce the result we get in the market. Social planning in this sense would be inefficient.

7. markets vs. planning Prices in the market carry information about demanders and suppliers desires to buy or sell goods and services. No one person has to know everything in the market because the price conveys information about relative value to all. But there are some interesting issues that we raise next by looking at more examples.

8. adverse selection Let’s consider a world of used cars where there are good ones and there are bad ones - lemons. Let’s look at how buyers and sellers value each type of car: good car lemon seller values 100 50 buyer values 120 60. With perfect information both buyer and seller know about the type of car. There is a set of prices at which both types of cars call be sold.

9. adverse selection Say buyers and sellers do not know what type of car they are dealing, but they think the chances are 50-50 between a good one and a lemon. In the market sellers expect cars to be worth the expected value = .5(100) + .5(50) = 75, and buyers expect cars to be worth .5(120) + .5 (60) = 90. All used cars would likely sell between 75 and 90.

10. adverse selection Now say only sellers know the type of car. At which price can cars sell for? -At prices above 100 sellers would offer all cars for sale. But when buyers do not know the type of car their expected value is 90 and thus would pay that for the car. So prices above 100 would not exist for long. -Prices between 60 and 100would have sellers sell only lemons. Buyers would soon find this out and then only offer 60 for cars. So prices above 60 would not last. -At prices below 50, no seller wants to sell.

11. adverse selection The only prices that can last are prices between 50 and 60 and then only lemons are offered for sale. In the presence of ‘asymmetric information’, trade in ‘high quality’ goods does not occur. So a lack of information on the part of some traders leads to less trade. This is an example of adverse selection.

12. Insurance Say you have 100 healthy people, people who have a 1 in 10 chance of being sick next period. Thus, next period you would expect 10 people from the group to be sick. We will talk about increments of $10 worth of doctor bills. Next period a person either pays 0 if they are not sick or $10 if they are sick. The expected payment per person is .1(10) + .9(0) = 1. So in any period the person can expect to pay out $1. Now this person wouldn’t pay more than $1 for insurance coverage of $10 because they would be buying more than they need.

13. Insurance Say the person would pay $2. Over the long haul they would find they pay in $2 per period but on average get out only $1 in benefits. These people wouldn’t do this for long. Insurance companies wouldn’t charge less than $1 because they would lose money over the long term. Now say there is another class of people called sicklies. They have a 9 in 10 chance of being sick next period. Their expected payment is .9(10) + .1(0) = 9.

14. Insurance By the logic similar to the healthies, insurance for the sicklies would cost $9 if insurance companies knew who they were. Now say the insurance company doesn’t know what group people fall into. Could it offer insurance to all at $1? NO!, it would lose money on the sicklies. If the insurance company offers $2 insurance some healthies drop out and it still loses money on the sicklies.

15. Insurance The insurance company would move toward insuring only the sicklies at $9. One group is ‘adversely’ selected to not participate in the market. So when the insurance company can not define the type of buyer, one type of buyer is driven from the market because the pricing structure has to cover the cost of doing business.

16. Summary In a world of perfect information, different classes of people pay different rates and all markets function. In a world where only buyers know their health risks only one market is formed - the sicklies market. Sickles end up paying the same either way, but healthies are driven from the market in a world of less than perfect information.

17. Moral hazard Moral hazard is the situation where before we insure we have one set of risks, but after the insurance is purchased we have a different set of risks. For example, without fire insurance we take precautions to not have a fire. This leads to a certain probably of fire. After insurance we tend to not take as many precautions and thus have a higher probability of having the fire. The insurance company will soon see this and charge us the higher rates and this will drive the truly cautious from the market.