I now move on to describe the moral hazard problem. This is a situation in which there is asymmetry of information with regard to the actions of the seller. In my regular class, I explain the concept of moral hazard by means of a classroom game. I would like to do the same now, although it is not possible during this video to play the game in real life. This game has been has been developed by Charles Holt and Roger Sherman and can be found in their paper entitled "Classroom Games, A Market for Lemons." I will now illustrate the rules of the game. Please take note of this information as I go through my next 4 slides. Then I will talk about the market implication of moral hazard using real outcomes obtained in my class. In this game, students play the role of buyers and sellers. Concretely, I will illustrate the case of 4 buyers and 3 sellers. These players interact in a market for a product that can have 3 quality levels: Low quality, medium quality, and high quality. All buyers and sellers are given the following information. This information is, therefore, public knowledge for all players of the game. So each seller chooses the price and the quality for his/her product. Higher quality costs more to produce, but is also worth more to the buyers. Each seller can sell up to two units. The second unit costs €1 more to produce compared to the first. Unsold units are not produced and therefore generate no cost. Once collected, the price and quality decisions of the seller are posted on the board by the professor for the buyers to see. Each buyer in turn can decide to purchase one unit from one seller at the conditions posted. Once each buyer has decided whether to buy and from wich seller to purchase, a new round is played with new production and consumption decision. Players are also publicly informed and the objective of each seller is to maximize his or her own profits. Profits for the sellers are calculated as the difference between the price at which they are sold and the cost of the quality that was produced. The objective of each buyer is to maximize his or her monetary utility. Monetary utility is calculated as the difference between the value of the purchase quality minus the price paid. Finally, players are given some private information. Buyers and only buyers learn about their willingness to pay for each of the three possible qualities. These are €4, €8,80 and €13,60 respectively of the low, medium and high quality. Sellers and only sellers learn about their production cost. These are €1,40, €4,60 and €11 respectively for producing the first unit of the low, medium, and high quality. For the second unit, the cost is €2,40, €5,60 and €12 respectively for the low, medium and high quality. Now it is your turn to act. With the information provided so far and the numbers presented in this table; in these two tables, please draw the demand and supply for each of the three possible quality levels. Consider a market in which there are there are only 4 sellers and 3 buyers. When you are done with your drawing, please click on continue. Hopefully your demand and supply representation looks like the one on this slide. P_l and S_l correspond to the demand and the supply of the low quality. D_m and S_m correspond to the medium quality. Finally D_h and S_h correspond to the demand and supply for the high quality. For each quality level, we have a supply and demand that cross at one point. For example, D_m and S_m cross at 4 units and at a price level of €5,60 Note that €5,60 is the cost for a seller of producing the second unit of the medium quality. Note that the y-intercept of each demand curve is at the buyers willingness to pay value for each quality level. Specifically, €5,60, €8,80 and €13,60 respectively for the low, medium and high quality. The y-intercept of its supply curve is of the level of the cost of producing the first unit. This is €1,40, €4,60 and €11 respectively for the low, medium and high quality. This demand and supply have a step-form because of the small number of market participants, the specific discrete cost structure and WTP structure. Note for example that the supply steps up at the level of the 3rd unit. This is because each of the 3 sellers in the market can produce the first unit at a lower cost than the second unit. Specifically the second unit cost one additional €1 as the supply steps up, so increases by €1 at this level. The exchange of either of the 3 quality levels generate a surplus in the market. As usual the surplus is represented by the area below the demand and above the supply. In each of the 3 cases should be easy to see that the largest surplus in this market is generated by the medium quality. This dashed area here represents the surplus from the medium quality.
