© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 15 Imperfect Information and Disappearing Markets

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Imperfect Information and Disappearing Markets A mixed market is a market where low-quality goods and high-quality goods are mixed together.A mixed market is a market where low-quality goods and high-quality goods are mixed together. AA market will break down, or the high-quality goods will tend to disappear, if either buyers or sellers are unable to distinguish between low- quality goods and high-quality goods.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Mixed Market for Used Cars In the model of supply and demand, the efficiency of markets is based on the assumption that buyers and sellers are fully informed.In the model of supply and demand, the efficiency of markets is based on the assumption that buyers and sellers are fully informed. Asymmetric information occurs when one side of the market – either buyers or sellers – has better information about the good than the other.Asymmetric information occurs when one side of the market – either buyers or sellers – has better information about the good than the other.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Mixed Market for Used Cars In such a market, the odds of getting a plum are small. The high-quality goods will tend to disappear and, in the extreme case, will be completely nonexistent.In such a market, the odds of getting a plum are small. The high-quality goods will tend to disappear and, in the extreme case, will be completely nonexistent. If buyers cannot distinguish between lemons (low-quality cars) and plums (high-quality cars), both will be sold together in a mixed market for the same price.If buyers cannot distinguish between lemons (low-quality cars) and plums (high-quality cars), both will be sold together in a mixed market for the same price.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Ignorant Consumers and Knowledgeable Sellers To determine the price in a mixed market we must answer these questions:To determine the price in a mixed market we must answer these questions: How much is the consumer willing to pay for a plum—a high-quality car?How much is the consumer willing to pay for a plum—a high-quality car? How much is the consumer willing to pay for a lemon—a low-quality car?How much is the consumer willing to pay for a lemon—a low-quality car? What is the chance that a used car purchased in the mixed market will be a lemon?What is the chance that a used car purchased in the mixed market will be a lemon?

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Market for Used Cars If buyers have neutral expectations (assume that there is a 50% chance of getting a lemon), they are willing to pay $3,000 for a used car.If buyers have neutral expectations (assume that there is a 50% chance of getting a lemon), they are willing to pay $3,000 for a used car.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Market for Used Cars The minimum price for plums is $2,500. At any price less than $2,500, no plums will be suppliedThe minimum price for plums is $2,500. At any price less than $2,500, no plums will be supplied The minimum price for lemons is $500. No lemons will be supplied at any price less than $500.The minimum price for lemons is $500. No lemons will be supplied at any price less than $500.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Market for Used Cars At a price of $3000, the supply of plums is 4 (point n ).At a price of $3000, the supply of plums is 4 (point n ).

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Market for Used Cars At a price of $2000, only lemons will be supplied (9 lemons, as show by point p ).At a price of $2000, only lemons will be supplied (9 lemons, as show by point p ). At a price of $3000, the supply of lemons is 16 (point m ).At a price of $3000, the supply of lemons is 16 (point m ).

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Equilibrium in the Mixed Market Neutral Expectations Assumed chance of lemon 50% Willingness to pay for lemon $2,000 Willingness to pay for plum $4,000 Willingness to pay for used car $3,000 Number of lemons supplied 16 Number of plums supplied 4 Total number of used cars 20 Actual chance of lemon 80% Neutral Expectations Assumed chance of lemon 50% Willingness to pay for lemon $2,000 Willingness to pay for plum $4,000 Willingness to pay for used car $3,000 Number of lemons supplied 16 Number of plums supplied 4 Total number of used cars 20 Actual chance of lemon 80%

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Equilibrium in the Mixed Market Pessimistic Expectations Assumed chance of lemon 100% Willingness to pay for lemon $2,000 Willingness to pay for plum $4,000 Willingness to pay for used car $2,000 Number of lemons supplied 9 Number of plums supplied 0 Total number of used cars 9 Actual chance of lemon 100% Pessimistic Expectations Assumed chance of lemon 100% Willingness to pay for lemon $2,000 Willingness to pay for plum $4,000 Willingness to pay for used car $2,000 Number of lemons supplied 9 Number of plums supplied 0 Total number of used cars 9 Actual chance of lemon 100%

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin All Used Cars are Lemons WhenWhen consumers’ expectations are consistent with their actual experiences, the equilibrium price of used cars is $2,000, and the plums will disappear from the market. Neutral Expectations Pessimistic Expectations Assumed chance of lemon 50%100% Willingness to pay for lemon $2,000$2,000 Willingness to pay for plum $4,000$4,000 Willingness to pay for used car $3,000$2,000 Number of lemons supplied 169 Number of plums supplied 40 Total number of used cars 209 Actual chance of lemon 80%100%

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Equilibrium in the Mixed Market The domination of the used-car market by lemons is an example of the adverse- selection problem. The quality of the goods left in the market is adverse, or undesirable.The domination of the used-car market by lemons is an example of the adverse- selection problem. The quality of the goods left in the market is adverse, or undesirable. Adverse selection is the result of the dynamics of asymmetric information (one side has better information than the other), which generates a downward spiral of price and quantity

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Thin Market for Plums It is possible that asymmetric information generates a thin market—one in which some high-quality goods are sold, but fewer than would be sold in a market with perfect information.It is possible that asymmetric information generates a thin market—one in which some high-quality goods are sold, but fewer than would be sold in a market with perfect information.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Thin Market for Plums If the chance of getting a plum is 10%, buyers are willing to pay $2,200 for a used car.If the chance of getting a plum is 10%, buyers are willing to pay $2,200 for a used car. Assumed chance of lemon 90% Willingness to pay for lemon $2,000 Willingness to pay for plum $4,000 Willingness to pay for used car $2,200 Number of lemons supplied 18 or 90% Number of plums supplied 2 or 10% Total number of used cars 20 or 100% Actual chance of lemon 90% TheThe market is in equilibrium because consumers accurately assess the chances of getting a lemon. AtAt an equilibrium price of $2,200, 20 cars are sold, 10% of which are plums.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Thin Market for Plums If buyers assume that there is a 90% chance of getting a lemon, they are willing to pay $2,200 for a used car.If buyers assume that there is a 90% chance of getting a lemon, they are willing to pay $2,200 for a used car.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Thin Market for Plums At this price, the supply of plums is 2 (point s ).At this price, the supply of plums is 2 (point s ). The supply of lemons at this price is 18 (point t )The supply of lemons at this price is 18 (point t ) The actual chance of getting a lemon is 90%, the same as the assumed chance of getting a lemon.The actual chance of getting a lemon is 90%, the same as the assumed chance of getting a lemon.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Money-Back Guarantees and Warranties The large gap between the willingness to pay and the willingness to accept provides clever entrepreneurs a profit opportunity if they can persuade skeptical consumers that a car is a plum and not a lemon.The large gap between the willingness to pay and the willingness to accept provides clever entrepreneurs a profit opportunity if they can persuade skeptical consumers that a car is a plum and not a lemon. Suppliers can identify a particular car as a plum in a sea of lemons by offering a guarantee:Suppliers can identify a particular car as a plum in a sea of lemons by offering a guarantee: Money-back guarantee: The seller offers to refund the price of the car if it turns out to be a lemon.Money-back guarantee: The seller offers to refund the price of the car if it turns out to be a lemon. Warranty and repair guarantee: The seller offers to cover any extraordinary repair costs for one year.Warranty and repair guarantee: The seller offers to cover any extraordinary repair costs for one year.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Lemons Laws Lemons laws require automakers to buy back cars that experience frequent problems in the first year of use.Lemons laws require automakers to buy back cars that experience frequent problems in the first year of use. A vehicle repurchased under the lemons law must be fixed before it is sold to another customer and must be identified as a lemon.A vehicle repurchased under the lemons law must be fixed before it is sold to another customer and must be identified as a lemon. A problem with enforcing these laws is that lemons can cross state lines without paper trails. New interstate commerce laws requiring the branding of cars as lemons on vehicle titles have been established.A problem with enforcing these laws is that lemons can cross state lines without paper trails. New interstate commerce laws requiring the branding of cars as lemons on vehicle titles have been established.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Used Baseball Players Baseball pitchers who are more prone to injuries tend to switch teams more often than pitchers who aren’t.Baseball pitchers who are more prone to injuries tend to switch teams more often than pitchers who aren’t. ThisThis happens because of asymmetric information and adverse selection. The new team has much less information than the old one.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Malpractice Insurance A person who buys an insurance policy knows much more about his or her risks than the insurance company.A person who buys an insurance policy knows much more about his or her risks than the insurance company. InsuranceInsurance companies must pick from an adverse or undesirable selection of customers. Buyers of insurance policies have more information than sellers.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Malpractice Insurance Careful physicians do not buy malpractice insurance because insurance companies are unable to distinguish between careful and reckless doctors.Careful physicians do not buy malpractice insurance because insurance companies are unable to distinguish between careful and reckless doctors. TheThe mixed market increases the cost of providing insurance and the price of the malpractice policy.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Pricing Health Insurance Until recently, insurance prices were based on a community rating—a price equal to the cost of providing coverage to the community or metropolitan area (every firm pays the same price for medical insurance).Until recently, insurance prices were based on a community rating—a price equal to the cost of providing coverage to the community or metropolitan area (every firm pays the same price for medical insurance). MostMost insurance companies now use experience rating—a price based on the medical history of the firm’s employees (a different price for each firm).

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Moral Hazard Moral hazard is a situation that encourages risky behavior.Moral hazard is a situation that encourages risky behavior. Insurance causes people to take greater risks. They don’t buy a fire extinguisher, or tend to drive recklessly. These are unobserved actions that increase the probability of a grim outcome.Insurance causes people to take greater risks. They don’t buy a fire extinguisher, or tend to drive recklessly. These are unobserved actions that increase the probability of a grim outcome. The moral hazard is pervasive. The availability of insurance, for example, decreases investment in prevention programs that reduce risk.The moral hazard is pervasive. The availability of insurance, for example, decreases investment in prevention programs that reduce risk.