Price vs quality

Asymmetric Pricing:

High Cost = Quality or

Quality= High Cost

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

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

Controlling Opportunistic BehaviorThrough 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.

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.

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.


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


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.

Markets for Lemons and Good CarsP

rice

of a

lem

on, $

0

Lemons per year

DL1,000

(a) Ma rket for Lemons

Pric

e of

a g

ood

car,

$

2,000

Good cars per year

DG

0

(b) Ma rket for Good Cars


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.

Markets for Lemons and Good CarsP

rice

of a

lem

on, $

750

0

Lemons per year

1,000

SL

DL

1,500

1,000


e

Pric

e of

a g

ood

car,

$

2,000

Good cars per year

1,000

S2

S1

DG

1,750

1,500

1,250

0


E

D*f F

D*


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


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.


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


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.

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.

Figure 19.1 Markets for Lemons and Good Cars

Pric

e of

a le

mon

, $

750

0

Lemons per year

1,000

SL

DL

D*1,500

1,000


f

e

Pric

e of

a g

ood

car,

$

2,000

Good cars per year

1,000

S2

S1

DG

D*

1,750

1,500

1,250

0


F

E


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.


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.


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

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.


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.


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.

Limiting Lemons

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

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.

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.

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.

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.

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.

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.

When Price Is Not Competitive.

Will all souvenir shops charge the same price? If so, what price will they charge?

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.

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.

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.

Price vs quality

Business

fixed quality

year good

fixed quality

variable quality

problems due

ma rket

trap model

quality cars