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QUESTION
Intro to Asymmetric Information in Markets
Homework: Intro to Asymmetric Information in Markets
Q1 The market for lemons
Recall the model of the market for used cars described in lecture. Explain in words why λ>1 is a necessary condition for a market for used cars to exist. Be concise.
Q2 Asymmetric Information and Counteracting Institutions
Akerlof claims that "numerous institutions arise to counteract the effects of quality uncertainty" and he provides four examples of such counteracting institutions.
Please provide two examples of institutions that counteract against the problems of asymmetric information. Briefly describe the specific problem that each institution is offsetting and exactly how each it mitigates the problem. Your examples do not need to come from Akerlof.
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Business |
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Answer
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Asymmetric Information in Markets
Q1 the Market for Lemons
Explain in words why λ>1 is a necessary condition for a market for used cars to exist.
Akerlof (1970) details that sellers know more about the products than potential buyers, and buyers are aware of this gap. Often, this asymmetry in information can affect the market equilibrium and in extreme cases, prevent the trade from taking place. Akerlof (1970) refers to this as an adverse selection model.
In the used car market, there are both good cars and lemons. Often the price of good cars will be higher as compared to that of lemons. However, the imperfect information distribution means that only sellers know which are good cars and those that are lemons. On the other hand, customers are not aware of those that are lemons but know that lemons or bad cars exist.
The quality of products available is endogenous to price, allowing the selling price to reflect the quality of cars. Taking λ to be the fraction of lemons in the used car market, with λ>1 being observed, the price of a randomly selected car will be pushed down significantly. As such, good cars may not be sold, allowing the lower prices only to reflect the quality of available cars which may be lemons but which buyers will be willing to pay for. If λ<1, buyers will not be willing to pay the new price for the available cars, thereby limiting trade.
Q2 Asymmetric Information and Counteracting Institutions
Counteracting against the Problems of Asymmetric Information.
Private mechanisms such as a warranty represent the primary entity that is fixing the issue of asymmetric information. Ideally, a warranty offsets the quality problem in the market by reducing quality uncertainty when purchasing products. Ideally, a warranty does this by guaranteeing the buyer that the product will remain valuable or without issues for a particular period; and if any problems occur, the seller will be responsible for correcting it.
Regulatory institutions are also helping counteract against the problems of asymmetric information. In this regard, they help improve the information flow to buyers by insisting on only particular goods to be on the market. More often, they limit potential low-quality products from getting to the markets. This way, buyers become cognizant of the probable quality of products, unlike in an adverse selection scenario where they have very little information about goods.
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