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Bad Money Derives Out Good Money .: Greshman 'S Law
Bad Money Derives Out Good Money .: Greshman 'S Law
lemons peaches
Sellers 1000 2500
Buyers 2000 3000
At a price between $1000 and $2500 the rational buyer suppose that
peaches does not appear in the market. So the cars worth only
$2000 to the buyers.
At any price above $2500 , the expected value (price) of the car to the
buyer is equal to 2333.3 = (1/3)(3000) + (2/3)(2000) <2500 .
There will not be any offer for peaches. Only lemons will be sold
for $2000 . (demand is perfectly elastic and supply is perfectly
inelastic.
KREPS CH 17 ADVERSE SELECTION & 4
MARKET SIGNALING
AKERLOF’S MODEL OF LEMONS
Suppose that there were two peaches for every lemon . So probabilities
are as follows ;
lemons ( P = 1/3) peaches (P = 2/3 )
Sellers $ 1000 $2500
Buyers $2000 $3000
Exp (buyer) = (1/3)(2000) + (2/3)($3000) = 2666.67 > 2500
This is enough for the owners of peaches to sell and we get the market
clearing price at 2666.67 with all the cars for sale . The buyer buys a car
at 2666.67 and he does not know whether it is lemon or peach. Owners
of peaches are not pleased about the lemons ; without them , peach
owners would be getting an extra of 333.33=3000-2666.67 for their
peaches . But at least peaches can be sold .
If a particular good or service comes in many different qualities , and in a
transaction one side but not the other knows the quality in advance , the
other side must worry that it will get an adverse selection out of
entire population .
KREPS CH 17 ADVERSE SELECTION & 5
MARKET SIGNALING
AKERLOF’S MODEL OF LEMONS
The classical example of this is in life /health insurance . If premiums
are set at fair rates for the population as a whole , insurance may be
a bad deal for healthy people , who then will refuse to buy .
The problem noted above becomes worse the greater the number of
qualities of cars and the smaller the valuation gap , the difference
between what a car is worth to a buyer and a seller , assuming they
have the same information . Note the following example ;
Imagine for example , that the quality spectrum of used cars runs from
real peaches , worth $2900 to sellers and $3000 to buyers , down to
real lemons , worth 1900 to sellers and 2000 to buyers . Between
the two extremes are cars of every quality level , always worth $100
more to buyers than sellers . The distribution of quality levels
between these two levels are uniform . Suppose that there are
10001 cars one of which worth $1900 to its owner and $2000 to
buyers, a second worth $1900.10 to its owner and $2000.10 to
buyers , and so on . Assuming inelastic supply and elastic demand
at every level of quality , what will be the equilibrium .
KREPS CH 17 ADVERSE SELECTION & 6
MARKET SIGNALING
AKERLOF’S MODEL OF LEMONS
Total number of cars = 10001 types
Each one represents a different ( quality ) kind
Quality of cars Worth to seller Worth to buyer Number offered
Real Peaches 2900 3000 10001
…………..
Tenth quality level 1901 2001 11
better
……..
………..
Second quality 1900.2 2000.2 3
level better
First quality level 1900.1 2000.1 2
better
Real Lemon 1900 2000 1
2100 demand
1900
quantity
2001 10001
The average car being sold is worth A= $(2000+P+100)/2 to the buyer. (Since
minimum price = 2000 and actual one is ( p +100 ) )
If P= 2100 , then A=P , { A=(2000+2100+100)/2 = 2100 }
If P>2100 ,then A < P , there will not be any demand .
If P< 2100 , then A > P , there will be infinite demand .
So demand is horizontal at p=2100 (figure slide 7)
Equilibrium price will be at p=2100 , with q=2001 supply of cars.
As it is seen , only 2001 out of 10001 of the total stock of car will be offered for
sale in the market .
p
avg
average value = q
s p
n
n q n = quality level of type n
Sn ( p) = number of quality level of type n
Let D( p ,qavg (p) ) be the demand function . It is decreasing in p and increasing
in qavg(p).
d D ( p ,qavg (p) ) /dp = ∂D/∂P + ( ∂D/ ∂q )( ∂qavg (p)/ ∂p )
(most likely positive ∂qavg (p)/ ∂p > 0 ) , ∂D/ ∂q >0 , ∂D/∂P < 0 → it might be
d D ( p ,qavg (p) ) /dp > 0 if the second term is big enough ,
KREPS CH 17 ADVERSE SELECTION & 10
MARKET SIGNALING
AKERLOF’S MODEL OF LEMONS
It is possible that for some price levels lower than p* the slope of
demand curve becomes positive [ d D( p ,qavg (p)/dp > 0 ] and does
not intersect the supply curve as it is shown in the following figure .
in these cases there will not be an equilibrium price and market
breaks down as it is in some health insurance market .
demand
price
supply
P*
quantity
1- in life insurance the high quality buyer distinguish himself from the low
quality buyer and take actions that is not worthwhile for low quality buyer .
2- in used car market The high quality seller may take actions which
distinguish him from the low quality seller and is not worthy for them .
with used cars ; a- seller may offer partial warranty or b- may get the car
checked by an independent party .
In life insurance ; a- medical checkups are sometimes required . Or ;
b- golden age policy may be used . No one will be turn down but only
the benefits will greatly reduced for the beginning years of the
insurance plan . If the buyer of the insurance knows that he is dying soon ,
or if he wants to use the benefits very soon , he will not gain the whole
benefit .
KREPS CH 17 ADVERSE SELECTION & 12
MARKET SIGNALING
SIGNALING QUALITY
Quality seller and his actions are not worthwhile for low quality workers.
One can think of adverse selection as an special case of moral hazard
and market signals as a special case of incentive schemes. The
incentives could be direct or indirect ;
1- direct incentives ; the seller of the low quality car may be tossed into jail
if he misrepresent the quality of car sold.
2- indirect incentives ; the seller of the used cars could be asked to give a
six month warranty if he says that the car is peach. Or the buyer may
offer $X if the seller offers him a warranty and $Y ( X>Y) , if he does not
offer him a warranty .
The two classic model of adverse selection in the literature are
1- SPENCE’S model of job market signaling and
2- ROTCHILD & STIGLITIZ model of insurance market .
In the present analysis the job market model (Spence’s setting )will be
used to illustrate both cases.
Imagine a population of workers with two qualities with equal
numbers ;
First – high quality with high innate ability , denoting t=2
Second – low quality with low innate ability , denoting with t=1
KREPS CH 17 ADVERSE SELECTION & 13
MARKET SIGNALING
SIGNALING QUALITY
There are firms that will hire the workers and operates in competitive
market and making zero pure profit.
Before going to work workers seek education that enhances their
productivity. But education can not move workers from low to
high quality level ,because it is intrinsic. Each worker chooses a
level of education from a set say from e=0 to e=16 (the numbers of
schooling).
A worker of type t ( t=1 , 2) and with education level of e ( e=1 , … 16 )
worth te to a firm .note that for every level of education higher
quality worker worth twice as much as lower quality ones . Firms
when they hire a worker are unable to tell whether the worker is able
or not . But they do get to see the worker’s CV and learn how many
years they have gone to school and make wages contingent on the
number of years they have spent in school .
Workers dislike education , and less able dislike education more .
Workers also want higher wages to be sure . Workers want to
maximize the following utility .
KREPS CH 17 ADVERSE SELECTION & 14
MARKET SIGNALING
SIGNALING QUALITY
Max U=Ut ( w , e ) ; where “w” is wage rate ,“e” is the education level
and “t” is the type of the worker.
Worker’s indifference curve is the
Utility is strictly increasing in “w” , locus of the combination of wage
and strictly decreasing in “e” . and education level which brings a
Shape of the worker’s indifference curve ; constant utility level . It is upward
sloping and strictly convex. Take
any point like P (or any other
w Indifference curve of point). Notice that at least one
low ability workers indifference curve for low ability
worker and one indifference curve
for high ability worker would pass
from this point The indifference
curve of high ability worker shows
Direction of
Wage paid
e1 e2
e
Education level
KREPS CH 17 ADVERSE SELECTION & 17
MARKET SIGNALING
SPENCE’S MODEL ; JOB MARKET SIGNALING
How many years Workers choose to go to school ?.They do so anticipating some
wage function w(e) that gives wages for every level of education .
Formally an equilibrium in the sense of Spence consist of ;
a – an anticipated wage function w(e) that workers anticipate will be paid to any
one obtaining this education level e and ,
b- probability distribution πt(e) on the set of education levels for each type of
worker , t= 1 , 2 , such that the following two conditions are met ;
b1 - For each type t worker and education level e → πt(e)> 0 only if
ut [w(e) , e] achieves the maximum value of ut [w(e) , e] over all e
Condition b1 says that based upon their anticipation , the workers choose that wage
level which maximizes their utility level
b2 - for each education level e such that; π1(e) + π2(e) > 0 ;
w(e) = e [0.5π1(e) ] / [0.5π1(e) + 0.5π2(e)] + 2e [0.5π2 (e) ] / [0.5π1(e) + 0.5π2(e)]
πt(e) gives the proportion of type t workers who select education level e in
equilibrium . So πt(e) is the probability of type t worker with education level of e
. 0.5 = probability of type t in the population (opulation of workers with two
qualities are assumed to be the same)
Condition b2 express that in the equilibrium which is attained under perfect competition
, the wage rate , w(e) is equal to the conditional expected value of a worker
presenting education level e. Since ability of workers are not observable , the
eqilibrium wage should be represented in terms of expected wage (both from
workers and employers point of view). For the simplicity we assume that all the
workers of a given type choose the same level of education :
KREPS CH 17 ADVERSE SELECTION & 18
MARKET SIGNALING
SIGNALING QUALITY
Two types of equilibrium - non observable quality (ability) ;
1-First type ; separating (screening ) equilibrium ;
All workers of type t=1 choose an education level e1 .
All workers of type t=2 choose an education level e2 .
Firms seeing the education level e1 , knowing the worker is of type 1 ,
pay a wage equal to e1 . And if they see the education level e2 ,
knowing the worker is of type 2 , pay a wage equal to 2e2 .
2-Second type ; pooling equilibrium ;
workers all pool at a single education level , e* , and the equilibrium wage
will be equal to ; firms by seeing educational level e* thinks that the
probability of worker from type 1 or 2 is 1/2 .
w(e) = ( e* ) ( 1/2) + 2( e* ) ( 1/2) = 1.5 e* {π1(e) = π2(e) }
1-First type - Separating equilibrium (non observable
quality);
In order to have an separating equilibrium each type of workers will
choose different level of education ; workers of type 1 would
rather choose the wage education pair ( w=e1 , e = e1 ) than
( w = 2e2 ,e = e2 ) and vice versa . Such an equilibrium could be seen
in the following figure .
KREPS CH 17 ADVERSE SELECTION & 19
MARKET SIGNALING
SIGNALING QUALITY W(e) curve must lie
both kinds of labors will maximize every where at or below
their utility levels with respect to the the indifference curves
expected wage constraint w(e) and F of the workers at the
Wage level
e1 e2 Education level
point E on w(e) is selected by low ability worker , so indifference
curve of low ability worker and W=e line should pass through point E and
point F on w(e) is selected by high ability worker so indifference curve
ofKREPS
high ability
CH 17worker and W=2e line should
ADVERSE pass through
SELECTION & point F 20
MARKET SIGNALING
What restriction should be placed on the points that are not selected
No specific restriction is needed except that ;
1- W(e) should be nonnegative for every level of e
2- we require that e ≤ w(e) ≤ 2e for all values of e .
3- it is also required that w(e)/e is non decreasing. (convex w(e) function)
first condition is self explanatory . Condition 2 says that if firms are
unsure about the worker’s ability level , firms can not be certain about
the level of education ( e or 2e ) . But according to the competition
among the firm they never pay more than 2e and not less than e . As
for condition 3 , workers assume that firms will asses a worker
who chooses education level e will be of low ability with probability
a(e). Assuming that firms all are risk neutral the wage which will be
paid in this competitive situation will be ;
w(e) = a(e) e + [ 1 - a(e) ] 2e
or w(e)/e = a(e) + [ 1 - a(e) ]2 = 2 – a(e) .
if w(e)/e is non decreasing , the a(e) should be non increasing
This means that with increase in the level of education , the
probability of the worker to have low ability is decreasing . This
means that tan(α) is increasing and w(e) wil be convex towards
the horizental axis .
KREPS CH 17 ADVERSE SELECTION & 21
MARKET SIGNALING
SIGNALING QUALITY
We could rephrase the condition 2 in the following manner ; a(e) is the
probability of low ability worker choosing education level e . So firms
assessments given by a(e) are confirmed at education levels that
workers do select in the equilibrium ;
a(e) = [ 0.5 π1(e) ] / [ 0.5 π1(e) + 0.5 π2 (e) ]
πt(e) gives the proportion of type t workers who select education level e in
equilibrium. population of workers with two qualities are in equal
numbers ;
.Note that in the figure in slide no 20 the w(e) function does not lie
between e and 2e . So it does not satisfy condition (b) .
W(e) curve
e* Education level
W’
equilibrium point E
E (contract E) is chosen
1.5 e* among different
points (different
contracts ) because it
has the highest utililty
among four different
dotted points
w’
E
E
w’
Indifference curve of low
ability workers .