THE MARKET FOR "LEMONS": QUALITY UNCERTAINTY AND - PowerPoint Presentation

THE MARKET FOR "LEMONS":QUALITY UNCERTAINTY AND THE MARKET MECHANISM Original: Jong-Kyung ParkModified by Hyeonsuh Lee Nahyun Oh Koshland Professor of Economics at the University of California, Berkeley 2001 Nobel Prize in Economics MIT (Ph.D.) ; Yale University (B.A.) GEORGE A. AKERLOF (1970)

The need for researchMicroeconomic theory models in the 1960s were characterized by their generic nature in which they dealt with perfect competition and general equilibrium. Situational and specific considerations were left out (such as information asymmetries).The existence of goods of many grades poses interesting and important problems for the theory of markets.

Research PurposeThe paper relates quality and uncertainty. Investigates the adverse selection problem. Explores the interaction of quality differences and uncertainty in explaining important institutions of the labor market.Gives structure to the statement: “Business in under-developed countries is difficult.”Determines the economic costs of dishonesty.

BuyerSeller Judge quality based on market statistics. Incentive to market poor quality goods.Reduction in the average quality of good and size of the market.Social and private returns differ. Sometimes, government intervention increases the welfare of parties.

Large price difference between new cars and those that have just left the showroom. After owning a specific car for a length of time, the car owner can form a good idea of its quality.An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers. The Automobile Market

“Bad money drives out good.” For most cars traded will be the “lemons,” and good cars may not be traded at all.  Bad cars tend to drive out the good.Because bad cars sell at the same prices as good cars. It is impossible for a buyer to tell the difference between a good car and a bad car; only the seller knows.Information asymmetry exists.Gresham’s law“The exchange rate is even.”“Both buyers and sellers know the difference between good and bad money.”

  Lemon Market Model Where: M is the consumption of goods other than automobiles, xi is the quality of the ith automobile, and n is the number of automobiles.

Model with Information Asymmetry Demand-Supply for group 1 Demand-Supply for group 2Demand Curve Supply Curve

Model with Information Asymmetry Table : Demand and Supply in Asymmetric Case The average quality of cars is only a half of the offering price. The buyer is uncertain about the quality of carsGroup 1 only wants to pay at P/2, while group 2 only wants to pay at 3/4p. No cars will be sold at price p.The price would go down, which further drives some sellers out of the market and further lowers down the average quality of cars, leading to the shrinking of the market. Price and Average qualityDemandSupply Equilibrium Group 1 Group 2 p < - p < - p > 0 0 N - Price and Average quality Demand Supply Equilibrium Group 1 Group 2 - - 0 0 N -

Model with Information Symmetry Supply DemandPriceDemandSupplyEquilliriumGroup 1Group200N-0N 0 N P=1 N P<1 0 - Table : Demand and Supply in Asymmetric Case

Model with Information Symmetry There is no equilibrium when price is above 3/2, because group 1 is willing to sell their car, but no group is willing to buy, since the reservation price of group 2 is only 3/2 and group 1 is only 1. When price is 3/2, only group 2 wants to buy the car, because price is still above the reservation price of group 1When price falls below 1, the equilibrium doesn't exist since group 1 doesn't want to supply/ sell their cars.Equilibrium of Supply and Demand in Symmetric Case

Under information asymmetry, insurance providers cannot discern between types of applicants (the healthy vs. unhealthy)Why doesn't the price rise to match the risk? As the price level rises, the people who insure themselves will be those who are increasingly certain that they will need the insurance. As a result, the average medical condition of insurance applicants deteriorates as the price level rises.Consequently, no insurance sales may take place at any price. InsuranceOne possible solution for adverse selection Group insurance

Race may serve as a good statistic for the applicant's social background, quality of schooling, and general job capabilities.The fact that some demographic groups are preferred to others is because employers make judgments about the average behavior of an observable group of people. Quality schooling may be a substitute for this statistic. Workers with high ability have lower costs of pursuing attainment of education at higher levels, which can act as a signal of their productive capacity. Employment of Minorities

In the example for the used car market, there is an incentive for the sellers to offer lemons at the market price. This lowers the expected quality of a good from the perspective of consumers; this drives legitimate goods out of business.Dishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty lies not only in the amount by which the purchaser is cheated but also the cost of loss incurred from driving legitimate business out of existence. Cost of Dishonesty

In India a major fraction of industrial enterprise is controlled by managing agencies. Promoter would turn to the agency because of its reputation, which would encourage confidence in the venture and stimulate investment.If there were symmetric information, investors would immediately know whether or not a venture was worth investing in, and there would be no need for additional spending on a managing agency to draw in more investment. The local moneylender charges extortionate rates to his clients.Cooperative Movement was meant to compete with local money lender.Lender A would retain all the borrowers below a threshold of riskiness and Lender B would find itself strapped with all the higher risk borrowers(lemons). Creates a barrier for entry in the market. Credit Market in Underdeveloped Countries

Institutions arise to counteract the effects of quality uncertainty Counteracting Institutions

Informal unwritten guarantees are preconditions for trade and production. Where these guarantees are indefinite, business will suffer as indicated by generalized Gresham's law. The difficulty of distinguishing good quality from bad is inherent in the business world.Institutions emerge to mitigate this uncertainty. Conclusion

A used-car salesperson may work to maintain his reputation rather than pass off a "lemon". Reputation is usually a good asset if one intends to continue business in the market.Discussion