The reason for market failures which we’ll take up is related to problem of imperfect information. When we buy some good (a “widget”) we some- times can’t tell, at first sight, if it’s of high or low quality. Sometimes we can get a good idea about quality at a low cost, and in this case the market for widgets can be divided into two, or more, groups, where high quality widgets sell at a premium price compared to lower quality widgets. Usually, high quality goods are more expensive to produce, so if both submarkets operate under perfect competition, the price difference reflects the difference in marginal (and average) costs. In some cases, however, it is very difficult for consumers to distinguish between high and low quality stuff; but the producer/seller has this knowledge. In such situations we say that there is asymmetric information, which can lead to a partial, or complete, market failure. The classical example (from Akerlof 1970) is the market for used cars.
A bad car is called a “lemon” in English (and a good car sometimes a “plum”). If I go to a car dealer and he tells me that a one year old car, which only has run 10000km, is as good as a new one and the price should therefore be just below the price of a new car, I should start to be suspicious. Why did the previous owner sell the car he just bought to the dealer, probably at a price well below the price he paid for it? Maybe he had learnt something about the car, which is difficult to see in the showroom and in a short test ride? Maybe the car is a “lemon”, with a user value below the price at which it could be sold at on the second hand market?
To simplify we assume that there are two types of cars already produced, plums (P) and lemons (L). Owners of a plum have a high reservation price, i.e., the price at which they are prepared to sell the price on the second hand market, while owners of lemons have a low reservation price. Let’s assume that ‾PP = 100tkr and ‾PL = 50tkr, where the bar below a letter indicates the lowest price at which a car of a particular type will be sold at on the market. The potential buyer’s reservation price is the highest price which she is prepared to pay for each type of car. Let’s assume that these prices are: " ‾PP = 120tkr and " ‾PL = 70tkr. Since the buyer cannot know whether a car is a plum or a lemon, we assume that her reservation price for a randomly picked car is:” ‾Pbuy = q. " ‾PP +(1 − q). " ‾PL; where q is the probability that the car is a plum. If q is high enough, both cars will be supplied on the market, i.e., if,
q. “‾PP + (1 − q).” ‾PL = ‾PP,
or (with our numerical values) when:
q . 120 + (1 − q) . 70 = 100,
which has the solution: q∗ = 3/5 .
What happens when q < 3/5? Let’s assume that q = 1/2 . This gives the following reservation price for the buyer,
1/2 .120 + 1/2 .70 = 95.
Note that this price is below the reservation price for sellers of plums, and it follows that no plums will be offered for sale on the market, only lemons.
However, if buyers understand this, their reservation price will not be 95 (which is based on the value of all cars, not the ones offered for sale on the second-hand market), but it will be, " ‾PL = 70tkr. The conclusion is that on the market for second-hand cars, only low-quality cars will be offered for sale, and the equilibrium price will be somewhere between ‾PL and “‾PL. There is no second-hand market for plums.
The problem with the market for used cars is that it’s not simple and costless to verify the quality of a given car and the supply of cars has been skewed, or biased, toward an overrepresentation of lemons (compared to their proportion in the entire population of cars). In equilibrium, this is reflected in the price, so both buyers and sellers are satisfied, but no trades in plums take place despite the presence of mutually beneficial gains from trade. The sellers of lemons produce an external effect since their supply lowers the buyers’ assessment of the average quality of cars supplied on the second-hand market.
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