29.1 Adverse Selection for Buyers: The Lemons Problem

• A low-quality car, also known as a “lemon”, breaks down frequently and has relatively high repair costs.

• A high-quality car, also known as a “plum”, is reliable and has relatively low repair costs.

• Suppose buyers can’t distinguish between lemons and plums

• An asymmetric situation is a situation in which one side of the market-either buyers or sellers-has better information than the other.

• A mixed market is a market in which goods of different qualities are sold for the same price.

• Suppose a typical buyer is willing to pay $4,000 for a plum and $2,000 for a lemon.

  • The buyer is willing to pay less for lemon because it is less reliable and has higher repair costs.

  • Someone who pays $2,000 and gets a lemon is just as happy as someone who pays $4,000 and gets plum.

• Consumer expectations play a key role in determining the market outcome when there is imperfect information.

  • Suppose half of the used cars on the road are lemons, and consumers know this.

  • A reasonable expectation for consumers is that half the cars on the used-car market will be lemons, too.

  • A buyer is willing to pay $3,000 for a 50-50 chance of getting either a plum or a lemon.

• In this equilibrium, no plums are bought or sold, so every buyer gets a lemon.

• An adverse-selection problem is a situation in which the uniformed side of the market must choose from an undesirable or adverse selection of goods.

• The asymmetric information in the market generates a downward spiral of price and quality:

  • The presence of low-quality goods on the market pulls down the price consumers are willing to pay.

  • The decrease in price decreases the number of high-quality goods supplied, decreasing the average quality of goods on the market.

  • The decrease in the average quality of goods on the market pulls down the price consumers are willing to pay again.

• In the extreme case, the downward spiral continues until all the cars on the market are lemons

• The plums disappeared from the market because informed plum owners decided to keep their cars rather than sell them at a relatively low price in the used-car market.

  • This outcome would change if the minimum supply price of plums were lower, specifically if it were below $2,000.

  • In this case, most but not all the used cars on the market will be lemons, and some lucky buyers will get plums.

  • This generates a thin market which is a market in which some high-quality goods are sold but fewer than would be sold in a market with perfect information.

• The lemons model makes two predictions about markets with asymmetric information.

  • First, the presence of low-quality goods in a market will at least reduce the number of high-quality goods in the market and may even eliminate them.

  • Second, buyers and sellers will respond to the lemons problem by investing in information and other means of distinguishing between low and high-quality goods.

29.2 Responding to the Lemons Problem

• The more information a buyer has, the greater the chance of picking a plum from the cars in the mixed market.

• ValueStar is a consumer guide and a business directory that uses customer satisfaction surveys to determine how well a firm does relative to its competitors in providing quality service.

  • To arm the right to display a Customer-rated seal from ValueStar, a form must prove that it has all the required licenses and insurance and must agree to pay for a survey of its past customers.

  • Any company receiving a score of at least 85 out of 100 has the right to display a Customer-Rated Gold seal for a 1-year period.

• On eBay, buyers must rely on sellers to honestly disclose the quality of the goods they are auctioning and to promptly ship them once a consumer pays.

  • Buyers help other purchasers distinguish “good” and “bad” sellers on eBay by rating them online with “stars”, indicating their satisfaction with their transactions.

• Sellers can identify. Car as a plum in a sea of lemon by offering one of the following guarantees:

  • The money-back-guarantee is where a seller could promise to refund the $4,000 price if the car turns out to be a lemon.

  • The warranties and repair guarantees are where the seller could promise to cover any extraordinary repair costs for 1 year.

29.3 Adverse Selection for Sellers: Insurance

• A person who buys an insurance policy knows much more about their risks and needs for insurance than the insurance company knows.

• Suppose half of the population is high cost and the other half is low cost. Assume the insurance company is somewhat naive and initially assumes that the mix of insurance buyers will be the same as the population mix.

  • In this case, the berate cost per customer is $4,000, that is, the average of $2,000 for each low-cost customer and $6,000 for each high-cost customer.

  • The demand curve for high-cost people is higher than the curve for low-cost people, reflecting their larger benefits from having medical insurance.

• The example of health insurance indicates that only high-cost people buy insurance.

• An experience rating is a situation in which insurance companies charge different prices for medical insurances to different firms depending on the past medical bills of a firm’s employees.

29.4 Insurance and Moral Hazard

• Insurance affects people's risk-taking behavior.

• Insurance causes people to take greater risks because they know part of the cost of an undesirable outcome will be borne by their insurance companies.

• This is an example of moral hazard, which is a situation in which one side of an economic relationship takes undesirable or costly actions that the other side of the relationship cannot observe.

• Insurance companies use various measures to decrease the moral-hazard problem.

  • Many insurance policies have deductibles where a dollar amount that a policyholder must pay before getting compensation from the insurance company.

  • Deductibles reduce the moral-hazard problem because they shift to the policyholder part of the cost of a claim on the policy.

29.5 The Economics of Consumer Search

• Suppose the price of a television ranges from $100 at the lowest-price store to $180 at the highest-price store.

• In addition, suppose that for a randomly selected store, any price from the low price to the high price is equally likely.

• Let’s assume that the opportunity cost of the time required to visit a store-the marginal cost of search- is constant at $0.90 per visit.

  • The marginal benefit of the search depends on your discovered price, which is the lowest price observed so far in a search process.

  • The marginal benefit of search is $1, which exceeds the $0.90 marginal cost.

  • Therefore, if your discovered price is $140, it is sensible to visit one more store.

• A reservation price is a price at which a consumer is indifferent about the additional search for a lower price.

• A consumer with a relatively high opportunity cost of search time will have a higher marginal cost of search and will naturally spend less time searching for a lower price.

• The higher the reservation price, the less time it will take, on average, to discover a price below the reservation price. Hence, a consumer with a high opportunity cost of search won’t spend as much time searching for low prices.

• The higher the price, the bigger the payoff from discovering a price.

• The smaller the gap between the low and high price, the smaller the possible savings from additional search.