CAS EC 101 Lecture Notes - Lecture 14: Perfect Competition, Adverse Selection, Moral Hazard

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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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CAS EC 101 Full Course Notes
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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.

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