Adverse Selection & Market Failure

1. Adverse Selection & Market Failure

2. Definition • Asymmetric information • occurs when traders of one side of the market know things that traders on the other side of the market do not. • Adverse selection • a condition which occurs in a market when buyer or sellers would, on average, be better off trading with someone selected at random from the population than with those who volunteer to trade.

3. Definition • Moral hazard • a condition which occurs when the actions taken by your trading partners are less favorable for you than the actions of the average member of the population. • Market failure • a condition which occurs when market cannot achieve an efficient allocation of resources.

4. Game Rules • Form a second-hand market for cars. • Class will be divided into 2 sides: • Used-car owners • Car buyers (dealers)

5. Instructions for used-car owners • You have a used car for sale. • If your car is still in good condition, then your reservation price* is $1200. • If your car is a lemon, i.e. a bad used-car, your reservation price is $0. • Only you know the condition of your used-car.

6. Instructions for used-car owners • You can sell your car at any price. Once you have decided your price and written down on a paper, you cannot change it. • After the deal, you can give the buyer the small piece of paper which you got from the draw determining the condition of your car. • When your selling price is higher than your reservation price, the difference between them is your profit.

7. Instructions for used-car buyers/ dealers • You want to buy used cars. You have $3000 to spend on buying cars. • You know that there are two types of used-cars in the market. They are either good used-cars or lemons, i.e. bad used-cars. • However, you have no idea what type of car a seller sells to you during the transaction. You will only discover the quality of the car shortly after you have bought it.

8. Instructions for used-car buyers/ dealers • For a good used-car, you can resell it at $2500. For a lemon, you can only resell it at $500. • You can decide whose car you want to buy after knowing sellers’ selling prices. • After the deal, the car seller you approached will give you a small piece of paper indicating the condition of the car you have bought. • When your buying price is lower than the price at which you can resell the car, the difference is your profit.

9. Game Rules • You have 2 minutes to think about your buying or selling price. • For used-car sellers, please write down: • Selling prices • The type of car you have, whether a good car or a lemon

10. 5 Minutes Trade • Now you have 5 minutes to trade. • Sellers can reveal your prices to buyers by putting up your price. • Buyers can approach sellers and decide whose car you want to buy. It is ok if you buy more than one car or you don’t buy any.

11. Time’s Up!

12. Discussion • Who have successfully sold your cars? • Is your car a lemon or a good one? • How did you set your price? • Did you tend to give wrong information to buyers? • Who could not sell your cars? • Can you explain why you couldn’t sell your car?

13. Discussion • How many buyers bought their cars? • Did you make a profit or a loss from this transaction? • How did you make your decision when you were in the used-car market? • How many buyers could not buy their cars? • Why couldn’t you buy a car? • How can we solve the problem of asymmetric information in real world?