Lemons

May 8, 2013

Announcements• Midterms passed back at end of class.• Assuming exams passed back this week, come to my office

hours Friday 11am-1pm if you think you deserve regrade.• Sun God festival next Friday – what should we do?• Remember, you have two chapters to read for Monday

along with problems– Start early!

Last Class

• Started our conversation on informational deficiencies.

• Saw that lack of information leads to buyers and sellers making inefficient decisions.

Learning Goals for Today

• Be able to define the free-rider problem using examples.

• Describe the lemons model and why there are theoretically only bad used cars for sale.– At odds with our conclusion last class: Why?

How much information?.

Markets that people Markets that people research before buying. research until MB=MC.

Will the Market Provide the Optimal Level of Information?

• In theory, information could be bought and sold just like any other good or service.

• BUT because information can be easily transferred from one person to the next, it’s hard to keep people who don’t pay for information from benefitting from it.

• Leads to a free-rider problem: any situation in which too little of a good or

service is produced because you can’t exclude people who don’t pay for a good or service from benefitting from it.

Will the Market Provide the Optimal Level of Information?

• People’s individual willingness to pay for information will be less than the social benefit of the information (since the information can costless be transferred to others). – Similar to the existence of a positive externality

• Markets will provide too little information.

Will the Market Provide the Optimal Level of Information?

• Example: go to Best Buy to learn about HDTVs, then buy online.– Best Buy covers the cost of the information it provides by

charging a little more.– If no one willing to pay the extra for a TV from Best Buy, Best

Buy will have a hard time providing good customer service.

Show-Rooming

Rise of smart-phones has resulted in consumers going to individual stores, and then searching for same product online to find similar prices.

What are some examples?

Show-Rooming

Rise of smart-phones has resulted in consumers going to individual stores, and then searching for same product online to find similar prices.

What is the ``story?’’

12

Factors That Affect the Marginal Benefit of Information/Search

• All else equal, people should spend the most time searching for products and services when– They are expensive.– There is a lot of variation in price/quality.

• Examples:

Some Definitions• Expected value of a gamble: the sum of the possible outcomes of the

gamble multiplied by their respective probabilities.• Fair gamble: a gamble whose expected value is zero.• Better-than-fair gamble: a gamble whose expected value is greater

than zero.• Risk-neutral person: someone who would accept any gamble that is

fair or better-than-fair.• Risk-averse person: someone who would refuse any fair gamble (that

is, they’ll only accept gambles that are more-than-fair).

Possible Outcomes and Probabilities

Expected Value

Gamble 1 $10 with probability .5 or-$10 with probability .5

Gamble 2 $1 million with probability .5 or-$1 million with probability .5

Gamble 3 $200 with probability .5 or-$100 with probability .5

Gamble 4 -$100 with probability .5 or$40 with probability .25 or

$400 with probability .25 or

Above is information on Jeans. Given your job pays $10/hr, what is the most time you should you spend in the store looking for an ``awesome’’ pair, rather than just grabbing a random one off the rack?

A. 30 minsB. 1 hourC. 1 hour 3 minsD. 2 hours

Value Cost Probability“Okay” $80 $80 0.50“Awesome” $100 $80 0.50

Search & Commitment Problems • Imperfect information means that potential trading partners may fear that

some better opportunity will come along.– This can make people reluctant to commit.– Otherwise productive exchanges may not take place.

• People find ways to commit themselves to remaining in the relationship.– Employment contracts– Rental agreements (year-long lease)– Return policies

• The claim: “it’s easier to get married than divorced”.

Asymmetric Information• Asymmetric information: situations in which buyers and sellers are

not equally well-informed.

• Examples:

Last Class: Your reservation price for a good used car is $5000. For a lemon is $1000. Given 20% of

all cars are lemons, we can predict that

A. only lemons sell, for $1k each.B. both types of cars sell, for $4200 each.C. only good cars sell, fro $4200 each.D. both reliable cars and lemons will sell for $1k

each.

The Lemons Model

• If buyers are risk neutral, they should be willing to pay $10,000.• But then people with good cars won’t sell their cars . . .

Sellers’ Reservation

Price

Buyers’ Willingness

to Pay

Probability of Each Type of

CarGood car $11,000 $12,000 .5

Bad car (lemon) $7,000 $8,000 .5

• All cars in the market will be bad cars.• Last class we said both cars sell for expected value given the buyers’

decision, but we didn’t take account of sellers’ decision. • Inefficient because some mutually beneficial exchanges will not

occur (good cars are never bought and sold even though they should be).

Sellers’ Reservation

Price

Buyers’ Willingness

to Pay

Probability of Each Type of

CarGood car $11,000 $12,000 0

Bad car (lemon) $7,000 $8,000 1

0 to 10 11 to 20 21 to 30 31 to 40 41 to 50 51 to 60 61 to 70 71 to 80 81 to 90 91 to 100

0

5

10

15

20

25

30

35

40

A’s

B’sC’s

Less than C

Max: 99Min: 10Avg: 63