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ASYMMETRIC

INFORMATION
AN OVERVIEW
• In the real world, households and firms do not have full information about the price,
quality and availability of the products.
• In fact, they only have imperfect information about opportunity set available to them.
• A leading example of imperfect information is asymmetric information about the
quality of used goods(eg, used cars in the market).
• Here, the sellers know about the true quality of their products, the buyers do not
know the quality of the used cars which may turn out to be ‘lemons’(ie, defective
pieces).
• Similarly, asymmetric information also occurs while the workers who sell their labor
services know their ability and efficiency, the firms who hire them are not well
informed about it.
• Price system in a competitive economy provides an efficient solution to the information problem.

• Prices play a big role in bringing about coordination in productive activities of the firms.

• Higher prices convey information to the firms what people prefer and adjust their productive activity
accordingly.

• Firms are guided by the price mechanism in deciding about what goods are to be produced and in what
quantities.

• Thus, prices serve as a signal to the firms of marginal benefits of producing extra units of various goods.

• Likewise, prices of inputs convey information to the firms about the extent of their scarcity.

• Firms try to economize on the relatively more scarce inputs and use relatively more cheap inputs.

• When there is imperfect information, for getting correct information buyers and firms are willing to pay for
it
• When it is not easy to know the quality of goods or it is costly to get information
about them and the buyers and sellers of goods are not equally informed about the
quality of goods, then there is asymmetric information.
• Thus, asymmetric information means the market situation when the buyers and
sellers have a different information while making a transaction.
• Important example of AI is the Market for Lemons, provision of insurance service
and labor market.
• The customer is better informed than the insurance company about the probability
of his getting ill.
• In case of labor market, different workers have different productivities and it is
difficult for the employer to know the productivity of the workers and other
employees.
THE MARKET FOR LEMONS

• The world lemon is used to describe a defective or low quality product.


• Let is consider the market for used cars, and assume that the used cars
are of different qualities; some are of good quality while others are just
lemons.
• While sellers of used cars fully know the quality of their used cars, the
buyers are uncertain about their quality due to lack of information.
• Therefore, the price of the used car in the market depends on the average
quality of the used car offered for sale.
• This is because the buyers being uninformed about the quality of the used
cars will not be willing to pay more than what an average quality used car
is worth.
• This means that the owners of bad quality cars will get price for their used cars more than what they are
worth.

• However, the owners of good quality cars will not be able to get the price for their better quality cars since
the price determined in the market for used cars will be equal only to what average quality used cars are
worth.

• As a result, the owners of good quality used cars will withdraw their cars from the market.

• This will reduce the number of used cars in the market.

• With this the average quality of used cars offered for sale will also go down, and so also the price of the
used cars.

• This will cause some more car owners whose used cars are of relatively good quality to go out of the
market.

• This process will continue until only the lemons are left for sale in the market.

• This phenomenon is called adverse selection as due to AI on the part of sellers and buyers the bad quality
products drive out the good quality products from the market.
ADVERSE SELECTION

• Adverse selection occurs when you attract those with whom you least want to
interact.
• AS is the direct result of asymmetric information; or in other words it is caused by
hidden information and so can be remedied by information acquisition.
• AS occurs in a market when buyers or sellers would, on average, be better off trading
with someone selected at random from the population than with those who
volunteer to trade.
• A classic example of adverse selection occurs in used-car markets.
• It can happen that in equilibrium, the used cars that come on to the market are not a
random selection from the population of used cars but just the worst ones.
Diagram and Discussion
• The problem of adverse selection also applies to insurance markets.
• The customers that are most likely to want insurance are the people who face the
highest risks.
• But these are people that insurance companies would least like to have as customers.
For eg:
- The people who most want to by collision insurance for their cars are those who
drive a lot and most likely to have accidents.
- The people who are most likely to buy health insurance are those who have reason
to think that they are going to have an expensive illness.
- People who are most likely to buy life insurance are those who have reason to
believe that they are likely to die soon.
Measures adopted to resolve Adverse Selection
• As discussed above, AI creates the lemon problem and drives good cars
out of the market.
• This harms the welfare of the owners of good quality cars who wants to
sell their cars.
• Thus, externality created by AI prevents the achievement of Pareto
efficiency and creates market failure.
• To resolve this problem, a few institutions have been developed:
- The provision of guarantees.
- Testing centers to check the quality of used cars.
- The use of brand names and franchisees.
MORAL HAZARD

• Another problem of AI, similar to adverse selection, is known in the


insurance industry as moral hazard.
• Moral Hazard arises when the behavior of the insuree changes after the
purchase of insurance so that the probability of loss or size of the loss
increases.
• An extreme example of MH is the insured’s incentive to burn his home
when he has been allowed to insure it for more than its market value.
• AS occurs when your trading partners have less favourable characteristics
than the population at large.
• MH occurs when the actions taken by your trading partners are less
favourable for you than the actions of the average member of the
population.
• Moral Hazard is sometimes called the case of ‘hidden action’.
• With MH, one side of the market is not able to observe the actions taken by the
people they deal with.
• Where MH is a problem, the market participant without information tries to monitor
performance of the participant with information, and to make this performance part
of the contract.
• Fire insurance companies have inspectors who observe precautions taken by their
large industrial customers.
• Auto theft insurers may give a discount to customers who have anti-theft devices
installed in their cars.
• Because monitoring is expensive, and usually imperfect, even with monitoring the
problem of MH remains a serious one.
Measures to reduce the problem of MH
• Insurance companies specify the precautions that individuals or firms buying
insurance must take to be eligible for making a claim.
• By specifying these conditions, the insurance company attempts to reduce the
probability of illness, accident or fire and thereby reduce the possible claims on it.
• Another method adopted is that of Co-Insurance.
• In co-insurance, the individual or firm shares a good portion of a potential loss with
the insurance company.
• A similar method to overcome MH is the provision of a ‘deductible’.
• Here, the individual or the insured has to pay part of the claim, and this ensures that
the insured individual will have incentive to take some amount of care.

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