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  1. 1. LemonsMay 8, 2013
  2. 2. Announcements• Midterms passed back at end of class.• Assuming exams passed back this week, come to myoffice hours Friday11am-1pm if you think you deserveregrade.• Sun God festival next Friday – what should we do?• Remember, you have two chapters to read for Mondayalong with problems– Start early!
  3. 3. Last Class• Started our conversation on informationaldeficiencies.• Saw that lack of information leads to buyersand sellers making inefficient decisions.
  4. 4. Learning Goals for Today• Be able to define the free-rider problem usingexamples.• Describe the lemons model and why there aretheoretically only bad used cars for sale.– At odds with our conclusion last class: Why?
  5. 5. How much information?.Markets that people Markets that peopleresearch before buying. research until MB=MC.
  6. 6. Will the Market Provide the OptimalLevel of Information?• In theory, information could be bought and sold just like any other good orservice.• BUT because information can be easily transferred from one person to thenext, it’s hard to keep people who don’t pay for information from benefittingfrom it.• Leads to a free-rider problem: any situation in which too little of a good orservice is produced because you can’t exclude people who don’t pay for agood or service from benefitting from it.
  7. 7. Will the Market Provide the OptimalLevel of Information?• People’s individual willingness to pay for information will be lessthan the social benefit of the information (since the informationcan costless be transferred to others).– Similar to the existence of a positive externality• Markets will provide too little information.
  8. 8. Will the Market Provide the OptimalLevel of Information?• Example: go to Best Buy to learn about HDTVs, then buy online.– Best Buy covers the cost of the information it provides bycharging a little more.– If no one willing to pay the extra for a TV from Best Buy, BestBuy will have a hard time providing good customer service.
  9. 9. Show-RoomingRise of smart-phones has resulted in consumersgoing to individual stores, and then searchingfor same product online to find similar prices.What are some examples?
  10. 10. Show-RoomingRise of smart-phones has resulted in consumersgoing to individual stores, and then searchingfor same product online to find similar prices.What is the ``story?’’
  11. 11. Factors That Affect the MarginalBenefit of Information/Search• All else equal, people should spend the most time searchingfor products and services when– They are expensive.– There is a lot of variation in price/quality.• Examples:12
  12. 12. Some Definitions• Expected value of a gamble: the sum of the possible outcomes ofthe gamble multiplied by their respective probabilities.• Fair gamble: a gamble whose expected value is zero.• Better-than-fair gamble: a gamble whose expected value is greaterthan zero.• Risk-neutral person: someone who would accept any gamble that isfair or better-than-fair.• Risk-averse person: someone who would refuse any fair gamble(that is, they’ll only accept gambles that are more-than-fair).
  13. 13. Possible Outcomes andProbabilitiesExpected ValueGamble 1 $10 with probability .5 or-$10 with probability .5Gamble 2 $1 million with probability .5 or-$1 million with probability .5Gamble 3 $200 with probability .5 or-$100 with probability .5Gamble 4 -$100 with probability .5 or$40 with probability .25or$400 with probability .25 or
  14. 14. Above is information on Jeans. Given your job pays $10/hr, what is the mosttime you should you spend in the store looking for an ``awesome’’ pair,rather than just grabbing a random one off the rack?A. 30 minsB. 1 hourC. 1 hour 3 minsD. 2 hoursValue Cost Probability“Okay” $80 $80 0.50“Awesome” $100 $80 0.50
  15. 15. Search & Commitment Problems• Imperfect information means that potential trading partners may fear thatsome better opportunity will come along.– This can make people reluctant to commit.– Otherwise productive exchanges may not take place.• People find ways to commit themselves to remaining in the relationship.– Employment contracts– Rental agreements (year-long lease)– Return policies• The claim: “it’s easier to get married than divorced”.
  16. 16. Asymmetric Information• Asymmetric information: situations in which buyers and sellers arenot equally well-informed.• Examples:
  17. 17. Last Class: Your reservation price for a good usedcar is $5000. For a lemon is $1000. Given 20% ofall cars are lemons, we can predict thatA. only lemons sell, for $1k each.B. both types of cars sell, for $4200 each.C. only good cars sell, fro $4200 each.D. both reliable cars and lemons will sell for $1keach.
  18. 18. The Lemons Model• If buyers are risk neutral, they should be willing to pay $10,000.• But then people with good cars won’t sell their cars . . .Sellers’ReservationPriceBuyers’Willingnessto PayProbabilityof Each Typeof CarGood car $11,000 $12,000 .5Bad car (lemon) $7,000 $8,000 .5
  19. 19. • All cars in the market will be bad cars.• Last class we said both cars sell for expected value given the buyers’decision, but we didn’t take account of sellers’ decision.• Inefficient because some mutually beneficial exchanges will notoccur (good cars are never bought and sold even though theyshould be).Sellers’ReservationPriceBuyers’Willingnessto PayProbabilityof Each Typeof CarGood car $11,000 $12,000 0Bad car (lemon) $7,000 $8,000 1
  20. 20. 05101520253035400 to 10 11 to 20 21 to 30 31 to 40 41 to 50 51 to 60 61 to 70 71 to 80 81 to 90 91 to 100A’sB’sC’sLess than CMax: 99Min: 10Avg: 63