CAS EC 101 Lecture Notes - Lecture 14: Perfect Competition, Adverse Selection, Moral Hazard
PERFECT COMPETITION
Objective 1: Three Conditions for Perfect Competition
• Many Buyers and Sellers
o There must be enough buyers and sellers so that no individual firm can have
control over market price
o Violations: result in monopoly, oligopoly, imperfect competition
• Complete Information – well informed buyers and sellers
o Buyers must know everything necessary in order to evaluate their transaction
properly
o Violations: result in asymmetric information
• Well-Specified Property Rights
o We must know who owns what
o Violations: result in externalities, public goods
Asymmetric Information
• Asymmetric Information – a situation where one party to a transaction knows more
than the other party
o Can be in the buyers’ or sellers’ favor
• 3 Problems from Asymmetric Information
o 1. Adverse Selection – when adverse selection occurs prior to a market
transaction
o 2. Moral Hazard – when adverse selection occurs after a market transaction
o 3. Principal-Agent Problem – a variant of moral hazard
Objective 3: Adverse Selection
• Adverse Selection – when adverse selection occurs prior to a market transaction
o Classified as any situation in which an uninformed party gets exactly the
wrong people wanting to trade with them
▪ Essentially, there is an adverse selection of the (better informed)
possible trading partners
o ex: used car market (the deprecation of cars so soon after purchasing),
insurance market, credit market
o numerical ex: WITHOUT asymmetric information
Max Price Offered (by buyers)
Max Price Wanted (by sellers)
Peaches
$20,000
$17,000
Lemons
$10,000
$8,000
• numerical ex: WITH asymmetric information
o probability of a peach (good car) = 50%
o probability of a lemon (bad car) = 50%
Max Price Offered (by buyers)
Max Price Wanted (by sellers)
Peaches
$15,000
$17,000
Lemons
$15,000
$8,000
o Maximum Offer (from a buyer) = (0.5 x $20,000) + (0.5 x $10,000) = $15,000
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▪ This is for any given car, regardless of if it is a peach or lemon
▪ The seller is at an advantage because they know whether the car is a peach
or lemon
▪ Peach = loss of $2,000
▪ Lemon = profit of $7,000
Objective 4: Problems of Adverse Selection
• Market Unraveling – when the adverse selection is so severe it goes away
o ex: instead of having a balance of peaches and lemons on the market, peaches
will disappear from the market leaving only lemons
Objective 5: Remedies to Adverse Selection
• Question: what can be done by the uninformed party to ensure that the informed party
has a valuable good/service?
o Market Screening – when the uninformed party attempts to gather information
about the product/service offered by the informed party
• Question: what can be done by the informed party to convince the uninformed party
that their good/service is valuable?
o Market Signaling – when the informed party sends signals to uninformed
parties conveying information about the quality of the product/service they are
trying to sell
▪ ex: word of mouth, reputation, branding, guarantees/warranties,
education, signals on the job, gifts
o Important to note that the signal must be effective in distinguishing between
levels of quality
▪ Signal will be costlier for a low-quality producer than for a high-
quality producer
Objective 6: Moral Hazard
• Moral Hazard – when adverse selection occurs after a market transaction
• Classified as the tendency of a transaction to change people’s incentives and therefore
their behavior
o ex: insurance market, on the job
Objective 7: Principal-Agent Problem
• Principal-Agent Problem – can be created anytime someone is hired to work for
someone else (ex: visiting a mechanic to fix a car, hire a lawyer, see a doctor, owning
shares of a company’s stock)
o A variant of moral hazard
• 2 Necessary Conditions:
o 1. Asymmetric Information – it must be difficult/costly for the principal to
monitor the actions of the agent
o 2. Divergent Interests – principal and agent must have different interests or
goals
• In order to fix this, one or both of the conditions must be fixed
o 2 Methods:
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▪ 1. Monitoring the agents to verify they are acting in the best interests
of the principal (ex: financial checking)
▪ 2. Must be able to align the interests of both the principal and agent
(ex: stock options – stock given to managers of companies but their
worth will only be as good as their company)
Objective 8: Introduction to Externalities
• Externalities – consequences for people who have no real involvement with
production (deals with the supply curve) or consumption (deals with the demand
curve)
o Remember that a supply curve shows how much quantity is produced at each
price while a demand curve shows how much additional benefit is received
from each price
• 2 Types of Externalities: Production & Consumption
o Both can result in spillover effects
• 2 Types of Effects: Positive & Negative
o Negative – having adverse consequences (ex: production – pollution,
consumption – smoking)
▪ Effects of production/consumption negatively benefit someone who is
not involved in production/consumption
o Positive – having beneficial consequences (ex: production – pollination,
consumption – flu-shots/vaccinations)
▪ Effects of production/consumption positively benefit someone who is
not involved in production/consumption
o Positive & Negative Trends:
Production
Consumption
Negative
MSC > MPC
MSC curve is above the MPC
(supply) curve
QEFF < QMKT
MSB < MPB
MSC curve is below the MPB
(demand) curve
QEFF < QMKT
Positive
MSC < MPC
MSC curve is below the MPC
(supply) curve
QEFF > QMKT
MSB > MPB
MSC curve is above the MPB
(demand) curve
QEFF > QMKT
▪ QEFF – Efficient Quantity Produced
• Where the MSC curve and MSB curve meets
▪ Question: is QEFF the amount that should be produced?
• Yes, because it does take into account the social benefits/costs
and inherently the additional cost imposed on society
• This point will maximize social surplus
▪ QMKT = Market Quantity Demanded
• Where the MSC and MPB (demand curve) curves meet
• Only takes into account private benefits and private costs
▪ Question: is QMKT the amount that should be produced?
• No, because it does not take into account the spillover effect
and inherently the additional cost imposed on society
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Document Summary
Asymmetric information: asymmetric information a situation where one party to a transaction knows more than the other party, can be in the buyers" or sellers" favor, 3 problems from asymmetric information, 1. Adverse selection when adverse selection occurs prior to a market transaction: 2. Moral hazard when adverse selection occurs after a market transaction: 3. Principal-agent problem a variant of moral hazard. ,000: probability of a peach (good car) = 50, probability of a lemon (bad car) = 50% Objective 6: moral hazard: moral hazard when adverse selection occurs after a market transaction, classified as the tendency of a transaction to change people"s incentives and therefore their behavior, ex: insurance market, on the job. Asymmetric information it must be difficult/costly for the principal to monitor the actions of the agent: 2. Divergent interests principal and agent must have different interests or goals. In order to fix this, one or both of the conditions must be fixed: 2 methods, 1.