Critical Review of Perfect Competition in Markets with Adverse Selection

Introduction

The article “Perfect Competition in Markets with Adverse Selection” by Eduardo M. Azevedo and Daniel Gottlieb discusses the concept of competition within the market. Some of the unique characteristics of competitive markets include a large number of producers that rival each other in meeting the needs of an equally large group of consumers. The unique aspect about a competitive market is that no single stakeholder has the power to dictate the direction of the business. In the same way, it is difficult for one group to determine the price of goods and the frequency of exchange. In unique cases, the market exhibits a perfect competition structure that comprises of a large number of numbers of producers and consumers. The only difference is that a single price prevails across the market.

Summary

Azevedo and Gottlieb discussed the occurrence of a market having a perfectly competitive model with adverse selection. In such a market setting, the two authors noted that the apparent lack of profits had the majority influence on prices. Adverse selective markets are highly regulated owing to the nature of risk that they display or the level of profit acquired. Additionally, their model also contained a set of endogenous traded contracts that were given significant attention given the impact of related policies. The third aspect analyzed in the article was that of erratic consumer behavior that included moral hazards and deviations from logical behavior. Lastly, the model incorporated the competitive equilibria inefficiencies. The rigid nature of traded contracts made it impossible for them to make any profits. It also addressed the government activities that would reinstate efficiency in the competitive market.

Critique

Perfect competition describes a market situation where there is a significant number of buyers and sellers limiting the existence of any monopolistic elements. Adverse selection is used to classify markets where the participants are influenced by irregular information. In such markets, one party seems to be disadvantaged and may pursue the formation of a contract or insurance that will safeguard them from any negative outcomes. The authors begin by identifying the effects of adverse selection in various markets. However, the information provided in the article reflects some of the features of a competitive market including the access to accurate and perfect information regarding the price and the lack of barriers to exiting and entering the market. Azevedo and Gottlieb recognize the need to establish a perfectly competitive model that will generate equilibrium in terms of the profits and disadvantages of each party.

Information regarding the drawbacks of adverse selection is acquired from previous scholarly studies done by Akerlof, Spence, Rothschild, and Stiglitz. The studies prove instrumental in understanding the impact of private information on the market and contract terms as well as dictate the nature of equilibria. The authors use ample support from the two models throughout the paper to clarify their perfectly competitive model in adverse selective markets. Theoretical models that are proposed by the authors are also supplemented by short case evaluations and examples. For instance, the case of an insurance market with candidate equilibrium reveals why the policy may not be traded because of its adverse condition in the market. The main objective is to reveal the factors that market players consider while trading in adverse markets such as contract distribution, cost, and consumer preference.

Section two of the article concentrates on identifying the applicable models that reinforce the perfectly competitive approach. It makes relevant assumptions that mimic the actual market segment or environment. The classic Akerlof,1970 model ensures that contracts are exogenously owing to the perceptions held by the regulators and participants which is a common aspect in perfectly competitive markets that possess a large number of buyers and sellers. The Rothschild and Stiglitz model has been used to determine the features of most contracts. The authors maintain a systematic argument providing a justification for any information that they provide. For instance, they identify the effect of the assumptions made at various sections such as section 2. Section 3 introduces the reader to the competitive equilibrium. Weak equilibriums are associated with zero profits rendering the prices similar to the costs.

The authors assess the equilibrium concept which is applicable in microeconomics and macroeconomics studies. In perfect competition, equilibrium is described as the point where the supply and demand are equal. According to the article, equilibrium is considered differentiable and continuous. Therefore, competitive equilibrium can be used as a reasonable prediction in adverse selective markets. However, this strategic model of determining the equilibrium price reveals an issue in the number of contracts that are available to the consumer. The article addresses the issue by using assumptions where organizations provide more than one contract similar to that offered for differentiated products and still experience losses. Capturing this concept is essential because attempts to meet the requirements of a perfectly competitive market.

The study fails to highlight some of the limitations of the proposed competitive model of adverse selection. In this case, the authors concentrate on the effect of equilibrium price and the number and nature of contracts. However, it fails to address some essential features of perfectly competitive markets such as the type of products offered and any transaction costs experienced. Such factors pose a threat to the engaged parties because it is likely to diminish the trade volume within a specific market. Ultimately, markets might suffer from unraveling and the knock-off effect. Nonetheless, they acknowledge the role of equilibria in increasing the efficiency within certain markets. The information proves to be instrumental while approaching markets that possess asymmetric information features.

Conclusion

Markets affected by adverse selection reveal some of the challenges that firms and organizations experience while attempting to engage in business activities. Such businesses are required to invest in insurance and contracts in order to safeguard them from any losses. However, the article proposes a system through which organizations in a perfectly competitive market can benefit from their business operations in presence of adverse selection. The authors propose a competitive equilibrium model that determines the contracts connected to supply and demand. Supply and demand are economic features that determine the price of a product, hence the profit or losses that a trader might experience.

References

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