Tag Archives: assymetric information

THE MARKET FOR LEMONS AND QUALITY CHOICE

THE MARKET FOR LEMONS AND QUALITY CHOICE

 

Whilst based on the course readings this summary is taken from Varian as the article itself is somewhat complex and doesn’t seem too relevant.

 

  • Asymmetric information may drive out high quality goods.
  • The seller knows the quality of his product but not the buyer. Lemons refers to the used car market whereby a “lemon” is a used car that is of poor quality and a “plum” is a used car of good quality. Both are offered to the market simultaneously.

 

 

Lemon

Plum

Buyer will pay

$1000

$2000

Seller will sell

$750

$1250

 

  • The quality of the car is not discernable to the buyer although the seller knows what type of car he is selling, hence the asymmetry of information.

 

  • Assuming buyers are risk neutral they will pay an amount equivalent to the expected utility of the car they receive which in the case of someone risk neutral, should be equal to the expected value of the car (i.e. the value of the average type of car available on the market). If there are 1000 lemons and 1000 plums then the expected value is:

 

E(U) = 0.5 * U(lemon) + 0.5 * U(plum) = (0.5 * $1000) + (0.5 * $2000) = $1500

 

How many cars are of what type are sold will depend upon the market price:

P < $750 No cars sold
$750 < P < $1250 Only lemons sold
$1250 < P All cars sold

 

  • Notice that there is no price at which only plums are sold. This indicates that if there is a market for goods of varying quality and consumers cannot distinguish, then all goods sell at the value of the best quality product.

 

Consider the following structure:

 

Lemon

Plum

Buyer will pay

$1200

$2400

Seller will sell

$1000

$2000

 

E(U) = 0.5($2400) + 0.5($1200) = $1800

 

  • But at this price only the lemons will sell as the value of the average car on the market is below the reservation price of those sellers of plums. As buyers are certain that at this price they will receive a lemon, no plums will sell even though the buyers will pay $400 above their asking price. This has potential to destroy the whole market for used cars as buyers are only willing to pay $1200 for a lemon. This is market failure.
  • Lemon owners put a negative externality on plum owners as they affect market perceptions about the average quality of used cars on the market.

 

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