Information and Markets

Reading in Acemoglu, Laibson List

Chapter 16
 Information and
Perfectly Competitive Markets
• In our model of an idealized market we assumed
that both buyers and sellers have perfect
information
– about prices
– about the quality of the good
• But there are many situations where one side of
the market is better-informed than the other – this
is a situation of asymmetric information
• And markets may not work well in these situations
 An Example
• You buy a new car
• You drive it out of the garage and immediately
try to sell it
• The price you get will be a lot less than what
you paid for it
• The most likely reason is that the potential
buyers suspect there is something wrong with
it if you are selling it so soon
 The Market for ‘Lemons’
• Suppose there are two types of cars:
– ‘plums’, worth £10k to buyers, £8k to sellers
– ‘lemons’, worth nothing to buyers and £1k to sellers
• If equal numbers of buyers and sellers and both buyers and
sellers know which cars are plums and which are lemons:
– The plums will be sold, at a price between £8k and £10k
– No-one will sell or buy a lemon
• Now suppose only the seller knows the quality of the car
before purchase
• In this case the price of both lemons and plums must be
the same
 With asymmetric information
1. The price of plums
will be above that of
lemons
2. The price of lemons
will be above that of
plums
3. All cars must sell for
the same price
 What Price Will Buyers
Be Prepared to Pay ?
• Remember, the buyer cannot tell before
purchase whether it is a plum or a lemon
• How much they are prepared to pay depends
on the fraction of lemons in the market
• Suppose fraction among owners is 25% and
buyers think all sellers will be in the market
• There is a 75% chance it is worth £10k, 25%
chance it is worth £0k so on average it is worth
£7.5k
 If the price is £7.5k which sellers will sell
their cars?
1. Only the owners of
plums
2. Only the owners of
lemons
3. Both types of owner
 So What Will Happen?
• The fraction of lemons in the market will be
£100%
• The maximum price a buyer will be prepared
to pay in this case is £0k
• No-one will sell and no-one will buy – the
market has collapsed.
• This is in spite of the fact that there are gains
from trade so it is a case of market failure
 Adverse Selection
• This is an example of adverse selection –
sellers of poor quality products have more
incentive to be in the market
• Sellers of good quality products have an
incentive to signal their quality (e.g. through
guarantees) but this may not be possible
• Some other examples of adverse selection
– Health insurance
– Interbank markets in the financial crisis
 Health Insurance
• If individuals have better information about their
health than the insurance company the buyers of
private health insurance are likely to be sicker-than-
average
• This drives up the cost which in turn encourages the
healthier not to buy it, making those with the
insurance even sicker
• and hence the price even more expensive..
• This is one reason we often see publicly-provided or
compulsory health insurance
 Interbank Markets
• Before the crisis, banks often lent to and
borrowed from each other when they were
either short of cash or had a bit too much of it
• The interest rate I will lend to you at depends
on how much risk there is that you will not
pay me back
• In the run-up to the financial crisis in 2007
some banks funded long-term mortgage
lending using short-term interbank borrowing
 The Financial Crisis
• In 2007/8 fears that some of these sub-prime
mortgages were not going to be paid back
meant that the affected banks were viewed as
more risky so could no longer borrow in the
interbank market
• Unable to borrow these banks went bankrupt
• This then became a loss for the banks who
had lent to them so now no-one wanted to
lend to these banks
 The Informational Problem
• Nobody knew which banks had lent to which
other banks
• No bank wanted to lend to any other bank for
fear that the other bank was in financial
difficulties
• Trying to borrow in the market was taken as a
sign that the bank had financial difficulties
• The market collapsed and we all suffered the
consequences – and still are 10 years later
The Volume of Interbank Lending, US
 What Happened Next?
• Central banks e.g. the Federal Reserve, the Bank
of England had to step in to lend to banks in
financial difficulties

• But confidence has still not returned to these

markets and they are still not working well

• Informational problems are an important part

of the problem
 Moral Hazard
• Adverse selection is not the only informational
problem
• Moral hazard occurs when the behaviour of
one party to a contract cannot be trusted to
carry out the terms of the contract
• For example, someone with car insurance may
drive less carefully because they will not pay
all the cost of damage if they have an accident
 Moral Hazard and the Financial Crisis
• Before 2007 many banks made very risky
loans
• When the risky loans went well, the bankers
got the profits.
• When the risky loans went badly, the banks
had to be bailed out by the taxpayer who paid
for the losses.
 Mervyn King, ex-Governor
of the Bank of England
“the massive support
extended to the banking
sector around the world,
while necessary to avert
economic disaster, has
created possibly the biggest
moral hazard in history”
Because bankers can take
risks knowing they will not
bear all the costs of any
losses
 Why Do You Think He Said That?
1. Because bankers can
take risks knowing
they will not bear all
the costs of any
losses
2. Because bankers
don’t know what
they are doing so
cannot be trusted
 Possible Solutions to
Moral Hazard Problems
• More Regulations to limit undesirable
behaviour
– E.g. on capital adequacy of banks
• More monitoring
– E.g. watching the riskiness on banks’ lending
• It is still very much up in the air how best to
regulate banks
 Conclusions
• Informational asymmetries are one source of
market failure

• While there are mechanisms to ameliorate

informational problems they are hard to
eliminate completely

• Informational problems played a considerable

part in the financial crisis
 Overcoming Informational Problems in
Markets
• Because informational problems can cause
serious problems in markets there are strong
incentives to overcome them
• There are a number of ways of doing this
– guarantees

• But lets consider one particular market

 (Illegal) Online Drugs Markets
• Illegal drugs in the past have been mostly traded on the
street
• But increasingly they are traded on the internet using
platforms:
– Silk Road 1.0 and 2.0
– Agora
– Evolution
• Illegality means have to have anonymity:
– Operate on TOR network so hard to find servers
– Use of bitcoins for transactions
• But this anonymity causes serious informational problems
Silk Road Homepage Screenshot
 What Informational Problems are there
Likely to Be
• As a buyer your concerns might be:
– If I place an order, will it be delivered?
– If it is delivered, is it what it claims to be?
– Is it a trap laid by the police?
• And if you are cheated by the seller, you might think
you have little comeback:
– Can’t complain to trading standards/police
– The sellers you are dealing with are criminals, the people
running the market are criminals, you are a criminal
– Its not John Lewis!
But in spite of this, these markets do
function and grow
 Policies to Deal with
Informational Problems
• There is a rating system by which buyers can
rate sellers
– Negative ratings <2% (only slightly higher than
eBay)
• Why is this not higher? What stops there
being huge numbers of ‘fake’ adverts?
• Cheat your customer, get a bad rating, but
then do the same with a different username
 Strategies to limit
the number of fake listings
• Payments from buyers are first paid into an escrow
account controlled by the platform
• Only released to the seller if there are no complaints
• But what is to stop the buyers complaining when there
is nothing wrong?
• If just one complaint likely no action will be taken but if
many complain then it will
• So a seller can probably cheat a few buyers but not a
lot – and each individual transaction is quite small
• But still might be worth it
 Posting a Bond
• The platform requires new sellers to buy a bond
• This acts as insurance against any rule-breaking
until you have proved to be ‘trust-worthy’
• One can understand why this helps to alleviate
informational problems between buyer and seller
• But the platform ends up controlling large sums
of money in the escrow accounts
• And the people running the platform are
criminals too!
 Can you trust the platform?
• Not entirely – Sheep Marketplace claimed to
be hacked and lost all its bitcoins. But many
think they just ran away with the money.
• Obviously this platform just collapsed
• So they had a one-off gain
• Market will only function if continuing
revenue is greater than potential gain from
cheating.
 Conclusions
• Putting aside arguments about whether drugs
should be legal or illegal, there are gains from trade
– people who want to buy drugs and people
prepared to sell them
• There are considerable obstacles to establishment
of conventional market – mostly informational
problems
• But institutions spring up to enable market to
function and grow – it is not perfect but it does
function