The document discusses asymmetric information in markets and how it can lead to inefficient outcomes. It provides examples of "lemons markets" where buyers cannot distinguish high-quality from low-quality goods. This can cause high-quality goods to be driven from the market if sellers cannot signal quality. The document also discusses how limited price information for consumers can give firms market power to charge above competitive prices, similar to a tourist trap model. Overall it analyzes how asymmetric information between buyers and sellers can disrupt efficient market outcomes.

1. Asymmetric Pricing:
High Cost = Quality
or
Quality= High Cost

2. Problems Due to Asymmetric
Information
 adverse selection - opportunism
characterized by an informed person’s
benefiting from trading or otherwise
contracting with a less-informed person
who does not know about an
unobserved characteristic of the
informed person

3. Problems Due to Asymmetric
Information
 moral hazard - opportunism
characterized by an informed person’s
taking advantage of a less informed
person through an unobserved action

4. Controlling Opportunistic Behavior
Through Universal Coverage
 Adverse selection can be prevented if
informed people have no choice.
 A government can avoid adverse selection
by providing insurance to everyone or by
mandating that everyone buy insurance.

5. Equalizing Information
 screening - an action taken by an
uninformed person to determine the
information possessed by informed
people.
 signaling - an action taken by an
informed person to send information to
an uninformed person.

6. Lemons Market with Fixed Quality
 When buyers cannot judge a product’s
quality before purchasing it, low-quality
products—lemons—may drive high-
quality products out of the market.

7. Lemons Market with Fixed Quality
 Cars that appear to be identical on the
outside often differ substantially in the
number of repairs they will need.
 Some cars —lemons— have a variety of
insidious problems that become apparent to
the owner only after the car has been driven
for a while.
 The seller of a used car knows from
experience whether the car is a lemon.
 We assume that the seller cannot alter the
quality of the used car

8. Lemons Market with Fixed Quality
 Suppose that there are many potential
buyers for used cars.
 All are willing to pay $1,000 for a lemon and
$2,000 for a good used car.

9. Markets for Lemons and Good Cars
(a) Ma rket f r Lemons
o (b) Ma rket or Good Cars
f
Prce of a good ca r, $
Prce of a lemon, $
2,000 DG
i
i
1,000 DL
0 0
Lemons per year Good cars per year

10. Lemons Market with Fixed Quality
 1,000 owners of lemons and 1,000 owners
of good cars are willing to sell.
 The reservation price of owners of lemons—
the lowest price at which they will sell their
cars—is $750.
 The reservation price of owners of high-
quality used cars is v, which is less than
$2,000.

11. Markets for Lemons and Good Cars
(a) Ma rket f r Lemons
o (b) Ma rket or Good Cars
f
Prce of a good ca r, $
Prce of a lemon, $
SL
E
2,000 DG
1,750
i
f S2 F
i
1,500 D* 1,500 D*
1,250
e S1
1,000 DL
750
0 1,000 0 1,000
Lemons per year Good cars per year

12. Lemons Market with Fixed Quality
 If both sellers and buyers know the quality
of all the used cars before any sales take
place, all the cars are sold, and good cars
sell for more than lemons.
This market is efficient because the goods
go to the people who value them the most.
All the cars are sold if everyone has the
same information

13. Lemons Market with Fixed Quality
 The amount of information they have
affects the price at which the cars sell.
 If no one can tell a lemon from a good car at
the time of purchase, both types of cars sell
for the same price.

14. Lemons Market with Fixed Quality
 Suppose that everyone is risk neutral and
no one can identify the lemons: Buyers
and sellers are equally ignorant.
 A buyer has an equal chance of buying a
lemon or a good car.
 The expected value of a used car is

15. Lemons Market with Fixed Quality
 This market is efficient because the cars
go to people who value them more than
their original owners.
Sellers of good-quality cars are implicitly
subsidizing sellers of lemons.

16. Asymmetric Information.
 If sellers know the quality but buyers do
not, this market may be inefficient:
 The better-quality cars may not be sold
even though buyers value good cars more
than sellers do.
 The equilibrium in this market depends on
whether the value that the owners of good
cars place on their cars, v, is greater or less
than the expected value of buyers, $1,500.

17. Figure 19.1 Markets for Lemons and
Good Cars
(a) Ma rket f r Lemons
o (b) Ma rket or Good Cars
f
Prce of a good ca r, $
Prce of a lemon, $
SL
E
2,000 DG
1,750
i
f S2 F
i
1,500 D* 1,500 D*
1,250
e S1
1,000 DL
750
0 1,000 0 1,000
Lemons per year Good cars per year

18. Asymmetric Information.
 Consequently, asymmetric information
does not cause an efficiency problem,
 but it does have equity implications.
 Sellers of lemons benefit and sellers of
good cars suffer from consumers’ inability
to distinguish quality.

19. Asymmetric Information.
 Now suppose that the sellers of good cars
place a value of v = $1,750 on their cars and
thus are unwilling to sell them for $1,500.
 As a result, the lemons drive good cars out of the
market.
 Buyers realize that, at any price less than $1,750,
they can buy only lemons.
 Consequently, in equilibrium, the 1,000 lemons sell
for the expected (and actual) price of $1,000, and
no good cars change hands.

20. Asymmetric Information.
 This equilibrium is inefficient because
high-quality cars remain in the hands of
people who value them less than
potential buyers do.

21. Lemons Market with Variable Quality
 Suppose that it costs $10 to produce a low-
quality book bag and $20 to produce a high-
quality bag,
 consumers cannot distinguish between the
products before purchase,
 there are no repeat purchases, and
 consumers value the bags at their cost of
production.
 The five firms in the market produce 100 bags
each.
 A firm produces only high-quality or only low-
quality bags.

22. Lemons Market with Variable Quality
 If one firm makes a high-quality bag and
all the others make low-quality bags, the
expected value per bag to consumers is
 Thus, if one firm raises the quality of its
product, all firms benefit because the bags
sell for $12 instead of $10.

23. Lemons Market with Variable Quality
 Because the high-quality firm incurs all
the expenses of raising quality, $10
extra per bag, and reaps only a fraction,
$2, of the benefits, it opts not to produce
the high-quality bags.
 Therefore, due to asymmetric
information, the firms do not produce
high-quality goods even though
consumers are willing to pay for the
extra quality.

24. Limiting Lemons
 Laws to Prevent Opportunism.
 Consumer Screening.
 Third-Party Comparisons.
 Standards and Certification.
 Signaling by Firms.

25. Price Discrimination Due to False
Beliefs About Quality
 One way in which firms confuse
consumers is to create noise by selling
virtually the same product under various
brand names.

26. Market Power from Price
Ignorance
 Suppose that many stores in a town sell
the same good.
 If consumers have full information about
prices, all stores charge the full-information
competitive price, p*.
 If one store were to raise its price above p*,
the store would lose all its business.
 Each store faces a residual demand curve
that is horizontal at the going market price
and has no market power.

27. Market Power from Price
Ignorance
 If consumers have limited information
about the price that firms charge for a
product, one store can charge more
than others and not lose all its
customers.
 Customers who do not know that the
product is available for less elsewhere keep
buying from the high-price store.
 Thus, each store faces a downward-sloping
residual demand curve and has some
market power.

28. Tourist-Trap Model
 You arrive in a small town near the site of the
discovery of gold in California. Souvenir shops crowd
the street. Wandering by one of these stores, you see
that it sells the town’s distinctive snowy: a plastic ball
filled with water and imitation snow featuring a model
of the Donner Party. You instantly decide that you
must buy at least one of these tasteful mementos—
perhaps more if the price is low enough. Your bus will
leave very soon, so you can’t check the price at each
shop to find the lowest price. Moreover, determining
which shop has the lowest price won’t be useful to
you in the future because you do not intend to return
anytime soon.

29. Tourist-Trap Model
 Let’s assume that you and other tourists
have a guidebook that reports how
many souvenir shops charge each
possible price for the snowy, but the
guidebook does not state the price at
any particular shop. There are many
tourists in your position, each with an
identical demand function.

30. Tourist-Trap Model
 It costs each tourist c in time and
expenses to visit a shop to check the
price or buy a snowy.
 Thus, if the price is p, the cost of buying a
snowy at the first shop you visit is p + c.
 If you go to two souvenir shops before
buying at the second shop, the cost of the
snowy is p + 2c.

31. When Price Is Not Competitive.
 Will all souvenir shops charge the same
price?
 If so, what price will they charge?

32. When Price Is Not Competitive.
 If all other shops charge p*, a firm can
profitably charge p1 = p* + ε,
 where ε, a small positive number, is the
shop’s price markup.
 If consumers have limited information
about price, an equilibrium in which all
firms charge the full-information,
competitive price is impossible.

33. Monopoly Price.
 Can there be an equilibrium in which all
stores charge the same price and that
price is higher than the competitive
price?
 The monopoly price may be an equilibrium
price.

34. Monopoly Price.
When consumers have asymmetric
information and when search costs and
the number of firms are large, the only
possible single-price equilibrium is at the
monopoly price.