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Asymmetric information and market disequilibrium - Essay Example

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Asymmetric information and market disequilibrium 1. Asymmetric information can result in markets leading to sub-optimal equilibria. (a) Show how this can lead to the complete absence of trade, even in the presence of willing buyers and willing sellers. In the domain of perfectly competitive market, one of the basic assumptions is that the buyers and the sellers have the perfect information about the market…
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Asymmetric information and market disequilibrium
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Download file to see previous pages Evidences state that asymmetric information has resulted in adverse selection and under provision or lack of trade (Cawley & Philipson, 1999, p.827). In the real markets cases often arise when the seller knows more about the product being traded than the buyers. As for example in case of second hand car market, the seller knows more about the car than the buyer. It may be the other way round also where the buyer posses more information than the sellers as for example in insurance market, the buyers of the insurance usually is more aware about their risks than the insurance company selling them the insurance. Labor market can be considered as another case where a labor trying to get a job is more aware of the fact that how able he is or she in convincing the employer to bag the job (Economics of organization, slide 4-6). The market of used car will be used as a model where the asymmetric information leads to the absence of trade in that market. The prediction of the conditions for the used cars is very hard to estimate. Various parameters to judge the conditions may be appearance of the car, existence of otherwise of a guarantee with the car, date of manufacturing and so on. But here the assumption will be that the buyer has only two sets of expectations or information in his mind that is the car is either good or the car is bad. The potential buyer also does not have the determination power of the condition of the car in ex ante situation (Economics of organization, slide 6). The seller is well informed about the condition of the car. If the car is in bad condition, the seller does not have the incentive to reveal the fact (Asymmetric Information, n.d). The willingness of the seller to sell a product is expressed in terms of reservation price. The reservation price of the seller is the price that the seller would accept for the object (Adverse Selection, n.d., p. 1) and it depends obviously on whether the car is good or bad. The reservation price of the seller is provided in the table below: Reservation Price Good condition Bad Condition $ 10, 000 6,000 Table 1. Similarly the buyers also evaluate the condition of the car which is also their reservation price (Onuma, n.d., p. 3). Now common information available to everyone is that half the sellers are selling good cars and half the sellers are selling bad cars. The reservation price of the buyer is provided in the table below: Reservation Price Good condition Bad Condition $ 11,000 7,000 Conjecture of the buyer In case of a risk neutral buyer the maximum amount he or she willing to pay for a used car is given in the expectation calculation of the buyer as given by, , Where E (B) = Expected buying price & probability of half of the sellers selling bad cars= probability of half of the sellers selling good cars= Now if the buyer gets to know about the reservation price of the seller, then he or she will work out the price calculation and will accordingly find that at the price only the seller of the bad car will be willing to sell the car because the sellers of only bad car’s reservation price is above $ 9,000 and the seller of the good cars’ ...Download file to see next pagesRead More
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