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ECON0301 Why Trade Liberalization may not be good

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Market Failures and Trade Ricardian model and H-O model predicts that trade liberalization is beneficial assuming the market functions well. Newer models predicts different outcomes: Dynamic Learning, External Economies of Scale (recall the Thai watch industry in the presence of the Swiss watch industry) Infant industry argument: an infant industry needs protection for it to thrive In the presence of market failures, whether trade liberalization is good is uncertain In fact, market failures may be exacerbated under trade liberalization

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External Economies and Market Failure

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Other Market Failures A few types of market failures Involuntary unemployment Credit rationing Bad product drives out good product These are easily studied by asymmetric information

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Asymmetric Information When a person buys medical insurance, the insuring company does not know whether the person is healthy. Nor does it know how well hell take care of himself after insured. The former type of asymmetry information is called a hidden type problem, or adverse selection problem. The latter type of asymmetric information is called a hidden action problem, or moral hazard problem. But the meaning of moral hazard has subsequently expanded. Information economics is the study of decision makings between agents when their information is asymmetric.

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Bad Product Drives out Good Product

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Adverse Selection Adverse selection refers to a situation where a selection process (here market) results in a pool of products/individuals with economically undesirable characteristics. With hidden type, either (1) bad products drive out good products or (2) good products subsidize bad products (both receive the same price). Greshams law: bad money drives out good. Or, where two media of exchange come into circulation together the more valuable will tend to disappear.

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Adverse selection: Used Cars (Lemons) Market Assumption: all of the above is commonly known in the following exercises, and all agents are risk neutral.

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Scenario I: Full Information Suppose that every buyer and every seller know the type of the car they are negotiating. Then both good cars and bad cars will be traded. There are simply two products (good and bad cars).

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Scenario II: No Information Suppose buyers dont know the type of the cars they are interested. Also suppose no sellers know the type of the cars they own. Expected valuation of a car to buyers= 1/3 * $30K + 2/3 * $20K = $23.33K Expected valuation of a car to sellers = 1/3 * $25K + 2/3 * $10K = $15K Both good cars and bad cars will be traded!

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Scenario III: Asymmetric (Unequal) Information Sellers know the types of cars they own. But buyers dont know the types of cars they are going to buy. Is a buyer willing to pay at a price greater than $25K (say $26K)? No, because there is 2/3 of probability that the car is bad, and the expected valuation to the buyer=1/3*$30K + 2/3*$20K= $23.33K < the price

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Scenario III: Asymmetric (Unequal) Information Is a buyer willing to pay a price of $22K to buy a car? No, at such a low price, only bad cars owners will sell their cars. But bad cars are worth only $20K to the buyer. $22K is too high a price. The market price is even lower, at $20K or somewhat lower. Only bad cars will be traded. Good cars dont find a buyer!!! Remark: What matters is not the amount of information.

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Scenario III: Asymmetric Information Good cars may still find a buyer, if the probability of bad cars in the pool is low. Let p be such prob. A buyer is willing to pay $25K if (1- p)x$30K + px$20K>$25K, or p