Review Session 2 Market imperfections (information asymmetries)

1. Review Session 2Market imperfections(information asymmetries) Catalina Martinez catalina.martinez@graduateinstitute.ch Office hours: Tuesdays 6-8pm Rigot 27 Economics and Development MDev 2012-2013 THE GRADUATE INSTITUTE | GENEVA

2. Agenda • Introduction • From IC and IQ to the market… • Demand and Supply curves • Consumer and producer surplus • Pareto efficiency • Market imperfections: Info asymmetries • Moral hazard • Adverse selection • Econometrics (summary of RS1, only if we have time)

3. Introduction • In the last RS we had many concepts, I know! The idea was to give you an overview and to provide you with the language that you need to understand the papers. • We will go over many of these concepts again in the next review sessions. • Today we will look at a simpler way of understanding Pareto efficiency which will help us to cover market failures (such as the ones happening in the credit market).

4. Quick summary of last time…

5. A C B U3 U2 U1 Consumers maximize utility given a budget constraint • Microeconomic theory helps us find where this happens: the relative prices of goods must be equal to the marginal rate of substitution Quantity of y Quantity of x

6. Example: You do not need to be able to solve this. Have a look only if it helps you to understand.

7. Example: You do not need to be able to solve this. Have a look only if it helps you to understand.

8. Firms maximize production given a cost function • Microeconomic theory helps us find where this happens: the relative prices of inputs must be equal to the rate of technical substitution Quantity of k A Q=constant Quantity of l

9. From indifference curves and isoquants to the market…. • Demand curves show the optimal decisions of various individuals: what prices would they be willing to pay to maximize their utility. • Supply curves show the optimal decisions of various firms: at what prices would they be willing to sell to maximize their profits. • We will see that Pareto efficiency is perhaps easier to understand from this point of view. • At the same time, market imperfections, such as the ones that occur in credit markets are easier to grasp.

10. Demand and supply • A demand curve is a model of quantities purchased in a given market and prices in that market. • That is, we only look at how quantities demanded change with price – all other factors influencing demand are held constant(ceteris paribus) • The demand curve is derived from individuals’ willingness to pay for the good (which comes from their max. of utility)

11. Demand for used textbooks • The demand curve is derived from individuals’ willingness to pay (solution of the max of utility problem) Price offered Willingness to pay 59 45 35 25 10 1 3 4 5 2 # of books demanded

12. The supply curve • The supply curve is a model of quantities offered in a given market and prices in that market. • That is, we only look at how quantities offered change with price – all other factors influencing supply are held constant (ceteris paribus) • The supply curve is derived from individuals’ (or firms’) costs (and the solution to their max of profits problem).

13. The supply curve of used textbooks • The supply curve is derived from firms’ willingness to sell at a given price (solution of the max of profits problem) Price asked 59 45 35 25 10 1 3 4 5 2 # of books supplied

14. Equilibrium in a perfectly competitive market • A perfectly competitive market is one where neither consumers nor producers can set prices by themselves (they are price-takers) • This can be guaranteed when there are great numbers of both consumers and producers. • Furthermore, a perfectly competitive market is characterized by free entry and exit and complete information.

15. Equilibrium in the textbook market price of books supply demand 59 at $45, 2 people want to buy a book but 4 people want to sell! 45 35 25 10 1 3 4 5 quantity of books 2

16. Equilibrium in the textbook market price of books supply demand 59 45 35 at $25, 4 people want to buy a book but 2 people want to sell! 25 10 1 3 4 5 quantity of books 2

17. Equilibrium in the textbook market A market equilibrium is a price at which the quantity supplied is exactly equal to the quantity demanded. price of books supply demand 59 45 at $35, 3 people want to buy a book and 3 people want to sell! 35 25 10 1 3 4 5 quantity of books 2

18. supply S price surplus E demand D quantity When markets are not in equilibrium • Price above its equilibrium level creates a surplus some producers are willing to lower theprice, drawing more consumers into the market. surplus = qS - qD

19. price quantity When markets are not in equilibrium (2) • Price below its equilibrium level creates a shortage some consumers are willing to pay more,drawing more producers into the market. supply S shortage = qD - qS E demand D shortage

20. price quantity When markets are not in equilibrium (3) • When a competitive market is out of equilibrium, market forces push it back • Without the competitive market assumptions, this does not necessarily happen supply S • This needs • complete information • free entry and exit Some consumers are willing to pay more, drawing more producers into the market E demand D shortage

21. Consumer and producer surplus • Consumer surplus is the net gain to an individual buyer from the purchase of a good. • Producer surplus is the net gain to an individual seller from the sale of a good. • Together, consumer and producer surplus are a measure of how much market participants benefit from the existence of the market (at a particular price).

22. Consumer surplus and the demand curve • As discussed previously, the demand curve reflects willingness to pay. • Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. • It is equal to the difference between a buyer’s willingness to pay and the price paid. • Total consumer surplus is the sum of individual consumer surpluses of all the buyers of the good.

23. Example: CS in the textbook market • At a price of $35, 3 people buy a book • Aleisha: $59- $35= $24 • Brad: $45- $35= $10 • Claudia: $35- $35= $0 • Total CS: $34 look at consumer surplus for those who buy price of books 59 24 45 10 35 25 10 quantity 3 4 5 1 2

24. Consumer surplus The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price. price … etc. Consumer surplus – the area under the demand curve and above the market price $1,500 D Quantity of computers 1 million

25. Price reductions will increase consumer surplus price Consumer surplus at price of $5,000 Increase in consumer surplus to original buyers $5,000 Consumer surplus gained by new buyers $1,500 D Quantity of computers 300,000 1 million

26. Producer surplus and the supply curve • The supply curve shows the potential seller’s cost at which he or she is willing to sell a good. • Individual producer surplus is the net gain to a seller from selling a good. It is equal to the difference between the price received and the seller’s cost. • Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of the good.

27. Example: PS in the textbook market • At a price of $35, 3 people sell a book • Engelbert: $35 - $10= $25 • Donna: $35 - $25= $10 • Carlos: $35 - $35= $0 • Total p. surplus: $35 look at producer surplus for those who sell Price asked 59 45 35 25 10 25 10 books supplied 1 3 4 5 2

28. Producer surplus more generally The total producer surplus generated by purchases of a good at a given price is equal to the area above the supply curve but below that price. price Producer surplus – the area under the demand curve and above the market price $1,500 S Quantity of computers 500,000

29. Producer surplus with a price increase The total producer surplus generated by purchases of a good at a given price is equal to the area above the supply curve but below that price. Surplus to new sellers price Increase in surplus to original sellers S $2,500 $1,500 Old producer surplus with price $1,500 Quantity of computers 500,000 800,000

30. Total surplus: consumer & producer surplus • The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. • Total surplus is the sum of the producer and consumer surplus. A A = Consumer surplus B = Producer surplus Total surplus = A + B price S $1,500 D B Quantity of computers 500,000

31. Market equilibrium and efficiency • The maximum total surplus is achieved at the market equilibrium in a competitive market. • In equilibrium there is no way to make some people better off without making others worseoff: PARETO EFFICIENCY (now we are back to RS1) • First Theorem of Welfare Economics: Competitive equilibriums are Pareto Efficient

32. Market equilibrium and efficiency –maximal surplus • Total surplus maximized at equilibrium allocation 1.0 D price Start at 0 and add quantities traded as long as the resulting surplus positive 0.8 0.6 S end at qe! 0.4 E1 Therefore, total surplus is maximized at qe 0.2 qe quantity 2 4 6 8 10 12

33. Market equilibrium and efficiency • Pareto efficiency: In equilibrium, you cannot make anyone (strictly) better off without making someone else worse off. • Try changing • identities of sellers/buyers • prices that individuals face price of books 59 S D 45 35 25 10 quantity 3 4 5 1 2

34. Market equilibrium and efficiency • Note that both definitions of efficiency are satisfied for any mechanism that implements the equilibrium outcome • However, the market implements the efficient allocation in a decentralized (and therefore cheap) fashion • only individual knowledge necessary • The statement “Markets are efficient” should not imply a normative statement as our definitions of efficiency are not meant to define ’the good’.

35. Market imperfections: Asymmetric Information

36. Asymmetric information • Asymmetric information takes place when some parties have more information than others about a transaction. • Examples: • A seller or producer knows more about the quality of the product than the buyer does • Managers know more about costs, competitive position and investment opportunities than firm owners • A firm possessing limited information about a potential worker’s abilities • A used car buyer not having complete repair and maintenance history on an auto • An insurance company not knowing risky behavior of a potential insurer • A bank has less information about the ability of the lender to invest money wisely and therefore to repay a loan. Chapter 17

37. The Principal-Agent Relationship • One important way in which asymmetric information may affect the allocation of resources is when one person hires another person to make decisions • patients hiring physicians • investors hiring financial advisors • car owners hiring mechanics • stockholders hiring managers • Landowners hiring peasants…we will see this when we do the lecture on land…

38. Adverse selection and moral hazard Asymmetry in information generates two types of outcomes • Adverse selection (hidden characteristic) • The equilibrium is biased by unobservable characteristics of some agents. • Moral hazard (hidden action) • The equilibrium is biased by unobservable actions of some agents.

39. Adverse Selection: Lemon Market (Akelrof, 1970) • Asymmetric information is relatively new area for applied economic analysis. In 1970 George A. Akerlof was first to address problems and solutions associated with adverse selection and he used the example of the market for used cars. • High quality cars • Low quality cars (Lemons) • The seller has the information but the buyer cannot distinguish between the two…asymmetric information (adverse selection: hidden characteristic)

40. The Market for Used Cars • High quality market • SH is supply and DH is demand for high quality • Low quality market • SL is supply and DL is demand for low quality • SH is higher than SL because owners of high quality cars need more money to sell them • DH is higher than DL because people are willing to pay more for higher quality Chapter 17

41. SH 10,000 DH SL 5,000 DL 50,000 50,000 If there is perfect info, there will be two markets because buyers and sellers know that the goods are different PH PL Market price for high quality cars is $10,000 Market price for low quality cars is $5000 50,000 of each type are sold QH QL Chapter 17

42. Since information is imperfect… • Sellers know more about the quality of the used car than the buyers • Initially buyers may think the odds are 50/50 that the car is high quality • Buyers will view all cars as medium quality with demand DM • Since sellers know what they are selling the supply curve will remain the same. Chapter 17

43. SH 10,000 7,500 DH SL 7,500 DM 5,000 DM DL DL 25,000 50,000 50,000 75,000 The Lemons Problem Medium quality cars sell for $7500 selling 25,000 high quality and 75,000 low quality PH PL QH QL

44. SH 10,000 7,500 DH SL 7,500 DM 5,000 DM DL DL 25,000 50,000 50,000 75,000 The Lemons Problem PH PL QH QL

45. SH 10,000 7,500 DH SL 7,500 DM 5,000 DM DLM DL DL DLM 25,000 50,000 50,000 75,000 The Lemons Problem The increase in QL reduces expectations and demand to DLM. The adjustment process continues until demand = DL. PH PL QH QL

46. Self-fulfilling expectations • With asymmetric information: • Low quality goods drive high quality goods out of the market- the lemons problem. • The market has failed to produce mutually beneficial trade. • Too many low and too few high quality cars are on the market. • Adverse selection occurs; the only cars on the market will be low quality cars. Chapter 17

47. Market for Insurance • Older individuals have difficulty purchasing health insurance at almost any price • They know more about their health than the insurance company • Because unhealthy people are more likely to want insurance, proportion of unhealthy people in the pool of insured people rises • Price of insurance rises so healthy people with low risk drop out – proportion of unhealthy people rises increasing price more Chapter 17

48. Market for Insurance • If auto insurance companies are targeting a certain population – males under 25 • They know some of the males have low probability of getting in an accident and some have a high probability • If can’t distinguish among insured, it will base premium on the average experience • Some with low risk will choose not to insure and with raises the accident probability and rates Chapter 17

49. Market for Insurance • A possible solution to this problem is to pool risks • Health insurance – government takes on role as with Medicare program • Problem of adverse selection is eliminated • Insurance companies will try to avoid risk by offering group health insurance policies at places of employment and thereby spreading risk over a large pool Chapter 17

50. Market for Credit: Stiglitz and Weiss • Asymmetric information: the bank does not know which customers are more likely to repay (even if it uses the customer credit history). • The interest rate of the loan becomes a screening device: • People willing to pay more, should be riskier. Indeed, they perceive the probability of repayment as being relatively low. • Self-fulfilling expectations: Raising interest rates makes it more difficult to make a successful project and to be able to repay the loan. • Moral Hazard (hidden action): The lenders have more incentives to default if the interest rate is too high. Chapter 17