Information theory Asymmetric information and its effect on market outcomes

Information asymmetry
Information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure in the worst case.

The market for lemon s
‡ Akerlof 1970 The Market for Lemons: Quality, Uncertainty and the Market Mechanism ‡ Akerlof investigates the effect of asymmetric information on the market equilibrium, based on the example of the used cars market. ‡ Assumptions: ± Used cars can either be of a good quality (Plum), or they can be faulty (Lemon). ± The seller knows the level of quality of his own car ± Potential buyers do not know the level of quality and cannot observe it asymmetric information ppt

How does this affect the market outcome?
The buyer cannot observe the quality of a particular car.
When meeting a car owner, he will only be prepared to offer a price which corresponds to the average quality of the cars on the market. He does not have any information which would allow to tailor his offer for a particular car.

The owner of a lemon:
Has no interest in revealing the information he has about the (low) quality of his car If he does so, he will receive a lower offer (by improving the information available to the buyer) By keeping the information for himself, he can expect a price higher than the value of the car market power

The owner of a plum:
Has no interest of selling his car at the average price offered by the buyers (he knows that the car is really worth more than the average offer) Crucial aspect: He cannot improve the information of the buyer by revealing the quality of the car ! This is because the real information (my car is a plum) is drowned by the noise made by the owners of lemons !! That s what they all say So his best option is to exit the market.

As a result the average quality of cars on the market decreases.

Another crucial aspect :
What happens if the buyers realise that the goods cars are exiting the market ? They reduce their average offer in line with the reduction in average quality
Following this reasoning, more owners of plums leave the market

In the end, the market disappears ! In theory, a market for lemons cannot exist for long

This is why you don t see spontaneous markets for second-hand cars...
The quality of a second-hand car can vary a lot. Buying a car, even second hand, is expensive. Concealing problems with a car is easy and cheap So buying a random car from a complete stranger is a big risk !!

One of the biggest market for lemons is ?? Online shopping Example: MP3/MP4 fraud

Grove yard selling

Buy (6,3) Leave (0,0) Buy (6-R,-12)

Kuhn Tree
Fresh Fresh

Seller Fresh

Leave (-6,0) Old Buy (6,-12) Old Leave (-6,0)

BUYER BL SELLER FF FO SELLER EXPECTED PAYOFF =2/3*6+(6-R)/3= 6-R/3 2/3*0 +1/3*(-6)=-2 2/3*6-1/3*6=2 0*2/3+1/3*(-6)=-2 6-R/3,-2 2,2 LL -2,0 -2,0

BUYER EXPECTED PAYOFF 2/3*3+1/3*(-12)=-2 2/3*0+1/3*0= 0 2/3*3-1/3*6=2 2/3*0+1/3*0=0

FF= The seller always says it is fresh whether it is fresh or old. FO= The seller tells the truth i.e. says fresh if it is fresh or says old if it is old.


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