Information Asymmetry and Market Imperfections: The Market for 'Lemons' and Winner's Curse | Study Guides, Projects, Research Law

Information Asymmetry Readings

Market of lemons

George Akerlof – The Market for ‘Lemons’: Quality uncertainty and the Market

mechanism

Incentive is for sellers to market poor quality products since the returns for good quality

accrue mainly to the entire group rather than the individual seller. Therefore there’s a

reduction in the average quality of goods and also the size of the market.

The model with automobiles as an example

The car market

People buy cars in this market not knowing whether it’ll be a good one or a lemon. After

owning the car for some time is only when the owner can form a good idea of its quality

which is more accurate than the initial idea on purchase.

Sellers have more knowledge about the quality of a car than the buyers. An owner of a good

car won’t receive the true value of his car in the market. Bad cars drive out the good cars

because they sell at the same price as good cars as its impossible for a buyer to know the

difference between the two.

Examples and applications

Insurance

As the insurance price level rises, the people who insure themselves will be those who are

increasingly certain that they’ll need insurance. The average medical condition of insurance

applicants deteriorates as the price level rises. This is analogous to cars where the average

quality of used cars supplied fell with a corresponding fall in the price level.

The insurance premiums for those over 65 are too high for any but for the least healthy which

shows adverse selection at these ages. Healthy term insurance policy holders may decide to

terminate their coverage when they become older and premiums rise. Adverse selection

happens when an individual has freedom to buy/not buy, to choose the amount or plan and to

persist/discontinue as a policy holder.

The employment of minorities

Employers may refuse to hire members of minority groups for certain types of jobs for profit

maximization. Race serves as a good statistic for social background, quality of schooling and

general job capabilities.

Good schooling helps cultivate the talents of a child. An untrained worker may have natural

talents which haven’t been certified by a credible school which slum schools are not,

decreasing the economic possibilities of their students. An employer therefore makes a

rational decision not to hire members of a particular race because it’s difficult to distinguish

between those with good qualifications and those with bad ones.

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Information Asymmetry Readings Market of lemons George Akerlof – The Market for ‘Lemons’: Quality uncertainty and the Market mechanism Incentive is for sellers to market poor quality products since the returns for good quality accrue mainly to the entire group rather than the individual seller. Therefore there’s a reduction in the average quality of goods and also the size of the market. The model with automobiles as an example The car market People buy cars in this market not knowing whether it’ll be a good one or a lemon. After owning the car for some time is only when the owner can form a good idea of its quality which is more accurate than the initial idea on purchase. Sellers have more knowledge about the quality of a car than the buyers. An owner of a good car won’t receive the true value of his car in the market. Bad cars drive out the good cars because they sell at the same price as good cars as its impossible for a buyer to know the difference between the two. Examples and applications Insurance As the insurance price level rises, the people who insure themselves will be those who are increasingly certain that they’ll need insurance. The average medical condition of insurance applicants deteriorates as the price level rises. This is analogous to cars where the average quality of used cars supplied fell with a corresponding fall in the price level. The insurance premiums for those over 65 are too high for any but for the least healthy which shows adverse selection at these ages. Healthy term insurance policy holders may decide to terminate their coverage when they become older and premiums rise. Adverse selection happens when an individual has freedom to buy/not buy, to choose the amount or plan and to persist/discontinue as a policy holder. The employment of minorities Employers may refuse to hire members of minority groups for certain types of jobs for profit maximization. Race serves as a good statistic for social background, quality of schooling and general job capabilities. Good schooling helps cultivate the talents of a child. An untrained worker may have natural talents which haven’t been certified by a credible school which slum schools are not, decreasing the economic possibilities of their students. An employer therefore makes a rational decision not to hire members of a particular race because it’s difficult to distinguish between those with good qualifications and those with bad ones.

The costs of dishonesty A market where goods are sold honestly and dishonestly (quality may be represented/misrepresented). Purchaser’s problem is to identity quality. The presence of people willing to sell inferior goods in the market drives out the good products. Dishonest dealings therefore drives out honest dealings from the market. People who wish to pawn bad wares as good wares tends to drive out the legitimate business. The cost therefore is the loss incurred from driving the legitimate business out of existence. Quality variation is greater in under-developed countries than it is undeveloped ones due to quality control in developed nations and lack thereof in underdeveloped ones. Counteracting institutions Institutions (methods) of counteracting the uncertainty: (i) guarantees – ensures the buyer of some normal expected quality. Risk is therefore borne by the seller rather than the buyer. (ii) brand names – indicate quality and gives consumer means of retaliation if the quality does not meet expectations because the consumer will then reduce/stop future purchases. (iii) licensing – e.g. for doctors, lawyers etc, most skilled labour carries some certification indicating attainment of certain levels of proficiency. Winner’s curse I won the Auction but don’t want the prize – Bazerman & Samuelson Winner’s curse – occurs in competitive situations when a successful buyer finds that she paid too much for a commodity of uncertain value. In an auction, two factors affect the magnitude of the curse: (i) degree of uncertainty on the value of the item, (ii) number of competitive bidders. The loss explains the fact that the object acquired is worth less than the price paid. The rationale for the overbidding can be explained by the fact that while the average bidder may accurately estimate the value of the good, some bidders will either underestimate it or overestimate it. The one with the highest estimation wins. Examples: -oil drilling rights with multiple bidders and uncertain info -acquisition of a company where actual value of target firm is uncertain -owner of a baseball team bidding for a few player who has ups and downs and your offer is accepted Winner’s curse here would say that perhaps the reason why you won is because you overestimated the actual value of the commodity.

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