WOLAITA SODO UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTEMENT OF ECONOMICS

ARTICLE REVIEW REPORT AS PART OF CONTINUOUS

ASSESSMENT OF THE COURSE ADVANCED MACROECONOMICS 2

Title:-Ricardian Equivalnce
By

John J. Seater

REVIEWER: 1. Afize Jemal Mohammed ID.NO Eco/MW/001/11

SUBMITTED TO:
Zegeye Paulos (Ass. Professor)

Sep, 2019
1. Summary

The main objective of the paper is to analyze market inefficiencies resulting from
information asymmetries. Specifically the paper tries relating quality and uncertainty,
Exploring interaction of quality differences and uncertainty in explaining important
institutions of the labor market. Give structure to the statement: "Business in under-
developed countries is difficult” and Determining the economic costs of dishonesty.

The basis for the author lemons model was his assumption that, in certain markets, sellers
will have a tendency to market poorer quality goods, as the benefits associated with the sale
of quality goods will accrue to the entire group of sellers constituting the market rather than
to the individual sellers offering the higher quality good alone. This process will gradually
lead to the prevalence of poorer quality goods in the market as the share of quality goods in
the market decreases, and then to a market failure where sales of the relevant good will not
take place regardless of the price. The author applied this theory to the market for cars. In
the car market, there are both new and used cars, good cars and lemons, and a new and
used car can be either a good car or a lemon. In both the new and used car markets, a buyer
will not know the exact quality of the car he is purchasing. Thus good cars and lemons will
tend towards the same price valuation. “Bad cars sell at the same price as good cars since it
is impossible for a buyer to tell the difference between a good and a bar car; only the seller
knows.” This in turn means that a good car is unlikely to be sold at its true or expected
value, thus continually increasing the prevalence of lemons in the market which in turn
contributes to a greater decrease in good cars, until the lemons entirely push the good cars
from the market.

In addition to the used car market, the author also noted the potential repercussions of
asymmetric information in the insurance market, in the context of minority employment
hiring, and credit markets in underdeveloped countries. Market failure is not a necessary
end to this process, but it is a possibility, as lower quality goods may increasingly drive out
higher quality goods ultimately causing the market for that good to cease to exist at all.
Market failure may be forestalled, however, by certain counteracting institutions which, in
essence, act as a minimal warrant of quality or value in situations where asymmetric
information might potentially be present. These institutions include: 1) guarantees, which
shift risk to the seller; 2) brand names, which indicate a uniform quality and give the buyer
recourse if the quality is inferior; 3) chains, which operate in a manner similar to brand-
names by ensuring quality across geographical regions; and 4) licensing and certification
practices, which ensure a minimal level of competency and proficiency.9 Despite the
possibility of palliative counteracting institutions, however, The author concluded that the
root cause of information asymmetries in markets is the very existence of those markets.
“The difficulty of distinguishing good quality from bad is inherent in the business world; this
may indeed explain many economic institutions and may in fact be one of the more
important aspects of uncertainty.”
2. Evaluation

First of all, it must be noted that the used-car market is not the best example of difficult-to-
overcome information asymmetries. As acknowledged by the author himself: “it should be
emphasized that this market is chosen for its concreteness and ease in understanding rather
than for its importance or realism.” In effect, there are many market mechanisms (that is,
solutions that do not involve new government regulations) through which quality
uncertainty in the used-car market can be minimized. It is well-known that car
manufacturers use differentiation techniques to market their vehicles and make them more
attractive to consumers. For instance, if one purchases a second-hand Mercedes or
Volkswagen, it is less likely that the car be a lemon. Therefore, the lack of information is
partly offset by the reputation of the car manufacturer.

However, the paper on the Market for ‘Lemons’: Quality Uncertainty and the Market
Mechanism, is so far the only theory that fully discusses the problems and effects of
asymmetric information within a market. The theory premises on the generalized Gresham's
law. Other theorist to have studied uncertainty include game theorists (the Prisoner's
Dilemma), but usually it have not been incorporated in the more traditional Arrow-Debreu
approach to uncertainty.

Even though, the author used a model from the automobile market to ascertain the adverse
effects of asymmetric information in the market. The results can be generalized to other
market as shown by the application of the model in the insurance market and this is the
more reason why businesses do not settle for marketable securities as the primary source of
finance, world over. The theory has got its limitations but its merits out-weigh the criticism.
Just like one famous author said it is better to be partially right than being accurately wrong.
Asymmetrical information is caused by imperfect information, in the automobile market,
when a seller knows more about the product than the buyer or when the seller withholds
important information about the car from the buyer. This creates dishonesty in the market,
which drives honest sellers and buyers away.

The paper describes how the interaction between quality heterogeneity and asymmetric
information can lead to the disappearance of a market where guarantees are indefinite. In
this model, as quality is undistinguishable beforehand by the buyer (due to the asymmetry
of information), incentives exist for the seller to pass off low-quality goods as higher-quality
ones. The buyer, however, takes this incentive into consideration, and takes the quality of
the goods to be uncertain. Only the average quality of the goods will be considered, which
in turn will have the side effect that goods that are above average in terms of quality will be
driven out of the market. This mechanism is repeated until a-no-trade equilibrium is
reached.

The article draws some conclusions about the cost of dishonesty in markets in general:
“   The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is
cheated; the cost also must include the loss incurred from driving legitimate business out of
existence.   ”

Summary of weaknesses and strengths of the article

The importance of information asymmetries could have driven the author towards the
waters of the nowadays standard mainstream economics. Theoretical Contributions The
theoretical contributions of the author could be retrospectively summarized in an
intellectual pilgrimage with four main steps, consisting in four discoveries: the importance
of asymmetric information, the possibility of code equilibrium, the presence of an identity
component within utility, and the macroeconomic negative consequences of norms. The
importance of asymmetric information on the used car model it is obvious that the sellers
know more about the quality of their cars than the buyers: If good and bad cars are sold at
the same price, owners are more likely to offer a bad car for sale than a good one. Potential
buyers of used cars suspect that the cars on the market are bad. Accordingly they reduce
the price they are willing to pay, reducing further the incentive to put a good car up for sale.
In a vicious circle, such interactions between the buyers and the sellers may even cause a
total market collapse. The next point to understand is that this problem is a general one,
potentially pervading all kinds of markets (credit, products, labor, and so on). However,
perhaps the right conclusion is not so much a problem about information, as about the
quality of information. Markets with quality as an unknown are much more fragile
machinery than markets without.

4. Weakness

The author’s paper is of the utmost importance for pointing out that information
asymmetries could potentially cause a suboptimal allocation of resources. Yet the main
example he employs to make his case (the market for used cars) does not represent
substantial market-coordination problems that can’t be overcome through other market
mechanisms. In addition, adverse selection does not seem to apply to the health insurance
industry, at least not in an important and substantial manner. The paper also ignores the
fact that consumers themselves can seek ways to assure the quality of a car and that a used-
car salesman may work to maintain his reputation rather than pass off a "lemon". The issue
of reputation, however, would not apply to private individual sellers who do not intend to
sell another car in the near future.

The other weakness of the paper is the regulatory approach proposed by the authors of the
paper, observing that some used-car markets haven't broken down even without lemon
legislation and that the lemon problem creates entrepreneurial opportunities for alternative
marketplaces or customers' knowledgeable friends Finally, the fact that economic agents
(and especially entrepreneurs) do not possess full information does not prevent them from
making optimal decisions based on available information. The heuristic and dynamic process
whereby agents buy, sell or invest within the market framework allows them to learn by
trial and error, overcoming in the long run the initial lack of knowledge.