Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

CHAP. 15] THE ECONOMICS OF INFORMATION 337
into five price classifications: Sellers of type I charge a price of $80 for the TV, type II sellers charge $90, type III charge
$100, type IV charge $110, and type V charge $120. For a single search, the probability of each price is 1/5, and
the expected price is the weighted average of all prices, or $100 [($80)(0,2) þ ($90)(0,2) þ ($100)(0,2) þ
($110)(0,2) þ ($120)(0,2) ¼ $100]. The consumer can now purchase the TV at the price of $100, or she can continue
the search for lower prices. With each additional search the consumer will find a lower price, until the lowest price of
$80 is found. The reduction in price with each search gives the marginal benefit of the search. The consumer will end
the search when the marginal benefit from the search equals the marginal cost.
EXAMPLE 3. The lowest TV price expected from one search for the case in Example 2 is:
Expected Price ¼ $80 þ $40 ¼ $100 (as found in Example 1)
1 þ 1
The approximate lowest expected price from two searches is $80 þ ($40/3) ¼ $93.33. Thus, the approximate marginal
benefit from the second search is $100 2 $93.33 ¼ $6.67. The lowest expected price with three searches is
$80 þ ($40/4) ¼ $90, so that MB ¼ $3.33. For four searches it is $80 þ ($40/5) ¼ $88, so that MB ¼ $2. For five
searches it is $80 þ ($40/6) ¼ $86.67, so that MB ¼ $1.33. If the marginal cost of each additional search for the consumer
is $2, the consumer should, therefore, conduct four searches. The higher is the price of the commodity, and the greater is
the range of product prices, the more searches a consumer will undertake (see Problem 15.5). Because consumers face
different marginal costs of search, they will end the search at different points and end up paying different prices for
the product.
15.3 ASYMMETRIC INFORMATION: THE MARKET FOR LEMONS AND
ADVERSE SELECTION
When one party to a transaction has more information than the other on the quality of the product (i.e., with
asymmetric information), the low-quality product or “lemon” will drive the high-quality product out of the
market. One way to overcome such a problem of adverse selection is for the buyer to get, or the seller to
provide, more information on the quality of the product or service. Such is the function of brand names,
chain retailers, professional licensing, and guarantees.
EXAMPLE 4. Insurance companies try to overcome the problem of adverse selection by requiring medical checkups,
charging different premiums for different age groups and occupations, and offering different rates of coinsurance,
amounts of deductibility, and length of contracts. The only way to avoid the problem entirely is with universal compulsory
health insurance. Credit companies reduce the adverse selection process that they face by sharing “credit histories” with
other insurance companies.
15.4 MARKET SIGNALING
The problem of adverse selection resulting from asymmetric information can be resolved or greatly
reduced by market signaling. Brand names, guarantees, and warranties are used as signals for higher-quality
products, for which consumers are willing to pay higher prices. The willingness to accept coinsurance and
deductibles signals low-risk individuals to whom insurance companies can charge lower premiums. Credit
companies use good credit histories to make more credit available to good-quality borrowers, and firms use
educational certificates to identify more-productive potential employees to receive higher salaries.
15.5 THE PROBLEM OF MORAL HAZARD
The insurance market faces also the problem of moral hazard, or the increase in the probability of an
illness, fire, or other accident when an individual is insured than when he or she is not. The reason is that
with insurance, the loss is shifted from the individual to the insurance company. If not contained, this could
lead to unacceptably high insurance costs. Insurance companies try to overcome the problem of moral
hazard by specifying the precautions that an individual or firm must take as a condition of insurance, and by
coinsurance (i.e., insuring only part of the possible loss).