Question

 

a. Suppose two potato chips companies (Firm 1 and Firm 2) face a market in which two new favors of chips (Spicy and Cheese) can be successfully introduced on the condition that each favor is introduced by only one firm. The payoffs are indicated as below.

		Firm 2
		Spicy	Cheese
Firm 1	Spicy	$-10, $-10	$20, $40
	Cheese	$40, $20	$-15, $-15

(Note: Firm 1’s payoff is entered before the comma, and Firm 2’s payoff is entered after the comma.)

i.What are the dominant strategies for Firm 1 and Firm 2 respectively?

ii. Is there any Nash equilibrium? Explain.

iii. Suppose Firm 1 can decide what strategy to play first. Draw the tree diagram and examine the Nash equilibrium (if any) of this sequential game.

b. Explain why the credit market is less efficient with the presence of asymmetric information.

Answer 1

 

b

Asymmetric Information refers to a situation what one party involved in a transaction has more information about the product than the other party.

In the credit market, there exists huge informational frictions. These frictions are applicable mainly on high risk borrowers. Basically, there can be two kinds of problems that can arise through asymmetric information:

- Adverse Selection: Borrowers who want to take high risk would be willing to borrow more as they don't repay the loan in future, Consequence of this is that higher interest rates prevail in the market with bad credit risks

- Moral Hazard: Borrowers may involve in risky activities without the permission of lender

With the presence of above problems, the Credit Market becomes less efficient as the only type of borrowers left in the market are bad credit risk type. Asymmetric information problems will wipe-out good credit risk from the market, making credit market inefficient.