Chapter 10 Asymmetric Information and Agency

1. Chapter 10 Asymmetric Information and Agency Overview of Information issue Asymmetric Information Application of the Lemons Principle Consumer information, prices, and quality

2. Overview of Information issue • Prefect Information VS imperfect information • Adverse selection in insurance market • Non profit hospitals • Supplier-induced demand (SID)

3. Asymmetric Information • The Lemon Principle-Akerlof(1970) Example (10-1): used cars available for sale vary in quality. Information asymmetry arises if the sellers know better the true quality of their cars than do the potential buyers. Suppose that nine cars are to be sold given by their quality from 0 (lemon) to 2(mint). Assume the potential buyers know only the distribution of quality. It is known that the reserve value to the seller=1000*Q and buyer’s value=1500*Q Step 1, if initial price=2000, all sellers agree to sell their cars. However, buyer do not know the quality of individual car, but they make a best guess the quality of 1 (average quality). Thus, buyers are willing to pay 1500 => No deal

4. Step 2: if auctioneer sets the price=1500. Unfortunately, two sellers of best cars will quit the market. Now the remaining highest quality level of 3/2, and the average quality will be ¾. Potential buyer will pay only 1500*3/4=1125 for any cars.=> No dealRepeat the steps=> The lemon principle: the bad one drivers out the good until no market is left (Adverse Selection).

5. Imperfect Versus Asymmetric Information • Imperfect information: owners and nonowners were uncertain of the quality Suppose that both owners and no-owners in previous example were uncertain of the quality but only the average quality of products. In step1, if price=2000=> no deal In step2, if auctioneer set price=1500, the owners are willing to sell nine cares because their reserve price=1000*1(average quality) • Deal

6. Application of Lemons Principle:Health Insurance • Information asymmetry will occur because potential insured persons know more about their expected health expenditures in the coming period than does the insurance company. • In Figure 10-2, the insurance company, expecting an average expenditure of 1/2M, would require a premium of a least 1/2M. In this case, all potential beneficiaries whose expected health expenditure below 1/2M will choose to self-insure • Solution: warranty, preexisting condition, experience rating in employer group

7. The agency relationship • Principle (patient) VS Agent (physician) • Monitoring • Dranove and White (1987): why physician are not reimbursed on the basis of improvements in patient health?Ans: asymmetric information

8. Consumer information, Prices, and Quality • Satterthwaite (1979) ad Paul and Satterthwaite (1981) identify primary medical care as a reputation good- a good for which consumers rely on the information provided by friends, neighbors and others to select from various services available in the market. • Under these conditions, authors shows that an increase in the number of providers can increase prices. The reasoning behind this surprising prediction is as follows: The economic idea is that reduced information tends to give each firm some additional monopoly power.

9. Consumer Information and quality • Searching cost • Informed consumers=>limiting price increasing • If consumers can distinguish quality, higher-quality will be rewarded with higher price • Negative ratings have a greater impact on consumers choice