Chapter 17: Asymmetric Information

Short Answer Questions

1. What is the main feature of a market characterised by asymmetric information? Answer: That the information about some of the properties of a good or resource is not disseminated symmetrically across all market participants. Thus, some market participants may be better informed than others. 2. What do economists mean by signalling and how can it be used to alleviate information asymmetries? Answer: A signal is an observable indicator of a hidden characteristic. When information is asymmetrically distributed it can be used to re-assure the less informed market participants about the type of the product/resource (i.e. to signal out its hidden characteristics). An example is long or money-back guarantees in the used car market (market for lemons). 3. What do economists mean by screening and how can it be used to alleviate information asymmetries? Answer: Like signalling, screening can be used to reveal hidden characteristics. Unlike signalling, however, screening is initiated and used by the less informed party to force the other group participants to reveal their true type (e.g. education or past experience as a screening mechanism for ability in the job market). 4. What is the adverse selection problem and how can it arise in the presence of information asymmetries? Answer: The phenomenon under which the uninformed side of a deal gets exactly the wrong people trading with it (that is, gets an adverse selection of the informed parties). 5. Briefly name and explain some real world examples of how markets response to adverse selection. Answer: Insurance and testing for AIDS, group health plans, targeted insurance rates (see section 17.2 for full discussion). For the remaining questions support your answers with the aid of appropriate diagrams. 6. Using the diagram to show the difference in preference of education and a all other goods between high-ability and low-ability graduates

Answer: When a low-ability person finds school to be more of a struggle than a highability person, a low-ability person has steeper indifference curves than a high-ability person

7. Education is often used as an effective signalling mechanism by graduates to signal their high ability and thus their appropriateness for the job. Using appropriate diagrams, explain how completion of university education may lead to a separating equilibrium. Answer: Because of the differences in their preferences, high-ability workers choose to go to university, point eH, whereas low-ability workers choose not to, point eL.

8. Fire home insurance schemes may actually give an incentive to insured agents to take less care of their homes, than they would actually do. Do you agree with this statement? Use a diagram to support your answer. Answer: With no insurance, the homeowner chooses the care level in which the marginal benefit is equal to marginal cost, point e1.When the homeowner purchases insurance, the marginal benefit of care shifts downwards from MB to MB. With insurance, the homeowners marginal benefit of care is equal to the marginal cost of care at point e2. Comparing points e1 and e2, we see that the homeowner undertakes less care when insured.

9. How would your answer to question 8 change if the scheme it was referring to was one of co-insurance (as opposed to full insurance)? Answer: With no insurance, the benefits of care are given by the top marginal benefit curve, MB, and the equilibrium is at point e1. Under full insurance, the homeowners benefits from care are given by the bottom marginal benefit curve, MB, and the equilibrium is at a low level of care, point e2. With a co-payment rate of 50 per cent, the marginal benefit curve, MB, falls between the no-insurance and full-insurance curves, and the equilibrium care level is at e3.

10. Briefly explain and using appropriate diagrams to show the equilibrium outcome when the amount of shrinking is observable. How much the owner has to pay the manager to keep him from quitting the job? Answer: The owners income is equal to the vertical distance between the curve and the managers indifference curve. When the amount of shirking is observable, the owner chooses the level of shirking at which this distance is greatest, s1 in the figure. At this level of shirking, the owners must pay the manager the amount of Y1 to keep him from quitting his job.

Essay questions 1. Discuss some of the most common forms of auctioning and use them to explain the concepts of private and common values. Answer: Most common types of auctions: (1) English or ascending auction (2) Dutch or descending auction (3) A sealed-bid auction. For full discussion see section 17.1

2. Under what conditions education may fail to act as an effective signalling mechanism for ability in labour markets? Answer: Education may fail to act as an effective signal of ability, if it fails to generate a separating equilibrium. This could happen, for instance, if the schooling disutility received by low-ability workers is not high enough. In that case, low-ability workers would receive education to pretend they are the high-ability type. 3. Discuss the implications of information asymmetry for the insurance market. Use appropriate diagrams to guide your arguments. Answer:

When Julie is not driven from the market entirely, the insurance company sets a premium that falls in between the two premia that it would charge in the fullinformation outcome. Since the equilibrium price is actuarially unfair in Bethans favour, she buys as much insurance as she can, point e6. Since the equilibrium price is actuarially unfair against Julie, she buys less than full insurance, point e7. 4. Discuss some of the most common types of government response to the problems raised by hidden characteristics. Answer: See section Government responses to hidden characteristics, p.662

5. Choosing an example of your choice, discuss the efficiency effects of moral hazard. Use diagrams to support your arguments. Answer: