Group 21 Núria Sánchez Sánchez

Núria Solana Basora

Mariona Domingo Gómez

Homework 5. Information Asymmetry: Adv. Selection

EXERCISE 1

There are 400 units of the model Toyota Auris 1.4 D-4D in the second-hand car market.
The valuations of buyers and sellers are the following

Price
Type (condition) Buyers’ Valuation Sellers’ Valuation
(if quality known)
Good (100 units) 4800 4000 4800
Medium (100 units) 3600 2900 3600
Bad (200 units) 2400 1500 2400

Both buyers and sellers know this table, with the proportion of cars of each quality level
as well as the values for buyers and sellers in general.

a. What would be the market price of a Toyota Auris 1.4 D-4D used car if both
sellers and buyers did not know the specific quality of the exchanged car?
Would the Toyota Auris 1.4 D-4D second hand cars’ market fail? Justify
your answer.

Unknown quality:

Seller: 4,000 · ¼ + 2,900 · ¼ + 1,500 · ½ = 2,475€

Buyer: 4,800 · ¼ + 3,600 · ¼ + 2,400 · ½ = 3,300€

All cars will be traded at a price of 3,300€.

b. In a more realistic case where there is asymmetric information and sellers

know the quality of their cars but buyers do not know, what will it happen?
Calculate the price, the number of cars finally sold and the wealth losses in
this case.

Known quality for sellers:

If p < 1,500€ no car will be sold.

If 1,500€ < p < 2,900€, the buyer will think it is bad and will value it in 2,400€.

If 2,900€ < p < 4,000€, the buyer will think it is medium and will value it in 2,800€.

If p > 4,000€, the buyer will value it in 3,300€.

There is no demand for p > 2,400€ because if p > 3,300€ there is no demand at all, and if
p < 2,900€ the buyer will perceive it as a bad car and only would accept to pay less than
2,400€.
Group 21 Núria Sánchez Sánchez
Núria Solana Basora
Mariona Domingo Gómez
c. What kind of solutions could you suggest to this problem?

I would suggest as a solution, for example, to offer product warranties and money back
guarantees.

EXERCISE 2

A group of consumers want to purchase a product. They value it at 12€ if it is of high

quality and it works properly, and at only 6€ if it is a product of low-quality but it works.
If the product is damaged (broken) they value it at zero, regardless of its quality. The
problem is that only the companies that sell these products know their quality. Consumers
only know that the probability of finding high quality products is 3/4. They also know
that only high-quality products break down with probability 1/3 while the low-quality
products deteriorate more easily, with a probability of 2/3.

(a) If a product is randomly selected, which price would consumers be willing to

pay? Explain your answer.

12€ · ¾ · 2/3 + 6€ · ¼ · 1/3 = 6.5€

(b) If the consumer knew that it is high quality how much would she be willing to
pay? And what about if she knew that it is low quality? Interpret and discuss your
answer.

High-quality: 12€ · 2/3 = 8€

Low-quality: 8€ · 1/3 = 2.66€

(c) Suppose now that firms can offer a guarantee (they just change the product that
does not work for another one that works). For the firm, the cost of changing the
product is c. If we know that only high-quality firms offer guarantee, how much
would consumers pay for a product with this guarantee? And for one without the
guarantee?

With guarantee: 8€ + c

Without guarantee: 8€

(d) What are the conditions, in terms of the cost c, that must be met for warranty to
serve as a signal of high quality? Write the (two) conditions and interpret the results.
What if the conditions were not met?

1. The cost c cannot be carried to those products with low quality

2. Applying the cost c must be profitable for quality products

If the conditions were not met, the cost c cannot be used as a signal.
Group 21 Núria Sánchez Sánchez
Núria Solana Basora
Mariona Domingo Gómez
CONCEPTUAL QUESTIONS

PROBLEM 1

Identify and comment if in the following situations we face a situation of moral hazard
or adverse selection:

i) The problem of hyper-prescription of drugs. Adverse selection

ii) A car manufacturer is looking for a provider of a new green battery. To get the contract,
some companies might "embellish" their results. Moral hazard

iii) The acquisition of a second hand car. Adverse selection

iv) After becoming a "fixed" employee, you reduce your effort. Moral hazard

v) The acquisition by a farm of a European certification of organic products. Adverse

selection

PROBLEM 2

The Stanford Business School, one of the leading business schools in the world, has
the policy of not disclosing neither the ranking, nor the grades of its master students
to the possible contracting firms. However, the school awards an additional
certificate from the school (besides the title) to the top 10% of the students with the
best grades and with a special mention to the best student of the cohort. Analyze
from an economic point of view the effects and possible causes of this practice. (You
should know that each year approximately 300 students graduate, virtually all of
those who began, and that for each offered position there are more than 50
applications from students from all over the world.).

When Stanford Business School decides not to disclose such information as the rankings
or the grades of their students with the possible contracting firms there’s an asymmetry
of information. Because the school and the students will have complete information about
the academic record, but the company will only know who the 30 best students of the
promotion are thanks to an additional certificate that the school makes.

This could be caused by the possible contracting firms, because when the companies saw
the rankings they focus only on the students of the top and forget and eliminate of their
list of potential employees the ones on the very bottom. This jeopardizes the students with
lower grades.

Using this method, the 270 students that do not have the extra certificate are seen the
same way by the companies, and all have the same chances to get an interview, not as if
they used the ranking.
Group 21 Núria Sánchez Sánchez
Núria Solana Basora
Mariona Domingo Gómez
While this is good for all the students in the Stanford Business School it might not be as
good for the contracting companies, because they do not have all the information of the
students’ academic record, the grades of the student normally are equivalent to the effort
they did, and the quality of their work. This could be information of interest for the
company and due to this policy of not disclosure the rankings and grades the companies
are worsen by not having this information.

PROBLEM 3

In the case of bank loans: explain briefly the problems of information asymmetries.
What do banks do to alleviate the problems with the loans (i.e., problems of moral
hazard and adverse selection)?

Information asymmetries affects the bank loans in terms of customers’ reaction. Bank
customers shows different behaviours when repaying credits. Lenders are, therefore,
uncertain about borrowers' quality, and depending on the knowledge a customer have
about such behaviour could arrive to generate a surplus for the bank. Thus, that profit
generated is what is called the asymmetric information between banks.

Banks need to deal with two different settings: the type of interest rate paid and the
comparison with the information-sharing and the symmetric information setting. We
assume that Banks are indifferent in both cases. Therefore, it depends on the customer:

One type of customer is the one that do not share information and the other type the one
that allows banks to share information, which makes a positive reaction for the bank.

Next, what is a microcredit? Who gets them? For the case of microcredits, how are
the adverse selection problems solved? Do they have more unpaid loans than regular
bank loans? Explain.

Microcredits are extremely small loans given to poor people in order to make them
become self-employed.

In an area where the institutions are competitive, risk neutral and in which they offer loans
contracts specifying the amount to be repaid only if a borrower's project makes a profit,
otherwise this borrower defaults on his contract. This are the kind of problems that can
exist when there is adverse selection.

To solve them, microcredits can be a potential solution. By bringing microcredits to

people, adverse selection problems can be mitigated because for example a borrower with
a low quality business project will obtain positive expected profit, businesses with high
quality will not be financed and so on.