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Asymmetric Information and Development

Asymmetric Information and Development. Development Economics @ ICEF Roman Zakharenko Spring 2014. Asymmetric information. The two parties of transaction, especially in developing countries, are often unequally informed about the goods traded Sellers know more about the good than buyers

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Asymmetric Information and Development

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  1. Asymmetric Information and Development Development Economics @ ICEF Roman Zakharenko Spring 2014

  2. Asymmetric information • The two parties of transaction, especially in developing countries, are often unequally informed about the goods traded • Sellers know more about the good than buyers • Insured people know more about their risk than insurance companies

  3. Adverse selection • Since buyers are not confident about quality, they cannot offer too much • Sellers of best products quit the market • This reduces average quality • This reduces the price buyers are willing to pay • More sellers quit • Idea first proposed by Akerlof (1970)

  4. Akerlof’s “Market for Lemons” • Two sides: buyers and sellers • Buyers’ value of a car is higher – optimal that all cars are eventually owned by buyers • Sellers observe the quality, buyers do not • Equilibrium: market may collapse, only lowest-quality cars sell

  5. Applications • Medical insurance: people of higher risk are more inclined to buy insurance – increase price of insurance – less risky people quit – average risk increases • Segregation by school (US): “slum schools” train, on average, low skilled workers – firms do not hire people from these schools (even if workers have high skill)

  6. Applications • Credit markets: more risky people are more likely to apply for credit – higher risk premium – drives out “safe” borrowers • These problems are especially important in developing countries

  7. Overcoming adverse selection • Signaling: sellers of good products offer warranty • University diploma signals about talents of a student • Seller’s reputation (knowledge of his/her past sales) • Recommendation by a third party • Government licensing

  8. Moral hazard • The term originates from insurance • Better covered individuals choose to be more risky • Application to development economics: sharecropping contracts • First proposed by Stiglitz (1974)

  9. Sharecropping contracts • Two parties: landlord (owns land) and tenant (owns labor); produce wheat • Production (crop) depends on (unobserved) effort of tenant, as well as (unobserved) random events (e.g. weather) • Therefore, the contract may only depend on (observed) total product

  10. Sharecropping contracts • What is the optimal contract? • Tenant takes all risks, landlord gets fixed revenue: too bad for risk-averse tenant • Landlord takes all risks, tenant gets fixed revenue: no incentive for tenant to work hard • Optimal to share the crop: tenant is partly insured from risk, but still has incentives to work

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