CLASS 14 OUTLINE

The Economics of Business

Harvard Extension SchoolFall 2011Instructor: Bob WaylandTeaching Assistant: Natasha Wambebe

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George Akerlof

Won 2001 Economic Nobel Prize for 1970 QJE article: “The Market for "Lemons": Quality Uncertainty and the Market Mechanism”

Not accepted immediately nor adopted widely for several years: “ a struggling attempt…”

Now a mainstay of understanding how asymmetric information may distort or damage markets

A structure for analysis of “economic costs of dishonesty”

Another case of divergence of social and private costsConcept is useful in exploring opportunities for

information-producing or sharing products

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Akerlof’s Used Car Market

Buyer has a notion that he has q probability of buying a good quality car; and (1-q) probability of a “lemon.”

Buyer cannot discern individual quality but has an idea of q

Buyer must assume all used cars are average quality and is only willing to pay that price

As a consequence, sellers of above-average vehicles tend to withhold them, sellers of below average vehicles tend to offer them

A destructive dynamic ensues in which q declines, expected average quality drops, even fewer good quality vehicles are offered….

Eventually the lemons may drive out the cream puffs

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Trader Types 1 and 2

Akerlof defined the demand, Qd, for used cars as function of price, p, and average quality of cars, μ

• Qd = D(p, μ)

Average quality, μ, is a function of price, p• μ = μ(p)

Supply, S, is a function of price, p• S = S(p)

Equilibrium: supply equals demand• D(p, μ) = S(p)

Begin by defining traders’ utility functions

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Table of Utilities for Traders Types 1 & 2

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Utilities for Trader Groups 1 and 2

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Relationship of Price and μ

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Asymmetric Information Case

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Symmetric Information Case

With symmetric information, the constraints due to ignorance and uncertainty are removed

Table shows demand curves for two price ranges and the total (last column)

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Symmetric Information Case, continued

The aggregate demand curve, Dp

Undefined?

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Supply Curve for the Symmetric Information Case

Supply, S, in the symmetrical information case is a 2

part function depending upon whether p>1 or p<1

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Symmetric Information Supply and Demand

Combining the supply and demand curves

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Examples of Lemon Principle

Medical Insurance Geezers find it difficult to buy medical insurance Government mandate to sell to pre-existing conditions creates

a moral hazard (geezer has the asymmetric information advantage)

Remedy is to require all to buy May be constitutional issues

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Examples of Lemon Principle, continued

Minority qualifications and hiring Minority status may be a fairly accurate indicator of

educational quality in U.S. School policies of social promotion and grade inflation

erode value of high school degree Employers cannot easily distinguish among top,

middle and bottom of high school graduates Special efforts to improve quality of minority

education and reestablish standards may raise the perceived average quality

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Examples of Lemon Principle, continued

Dishonesty Some merchants may exploit asymmetric

information to lie about the quality of their goods Even if some merchants are honest, the buyers

may not be able to distinguish the honest from the liars and so shun the market

In this case, the loss is not only lost sales by the crooks but loss of businesses by the honest merchants

In some cases, the government or an industry group may need to vouch for quality, particularly in underdeveloped countries

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Credit Markets in Undeveloped Countries

Commercial banks in undeveloped countries may not be able to distinguish credit worthiness Local moneylenders exploit the banks’ ignorance and

charge very high rates Similar things happen in poorer neighborhoods in the

U.S. (paycheck loans from Legbreaker, Kneecapper, and Knuckles Bank)

Micro credit has filled part of the void, risk management by group responsibility

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Counteracting the Lemon Principle

Independent information sources, e.g. VEHIX, Carfax, Emily’s List

Awards, e.g. Nobel PrizesGovernment standards, e.g. Appellation

d’Origine Controlées (AOC) and Vin de Pays (VDP)

Warranties and guarantees, e.g. Hyundai

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Pitchmen

Grand American Tradition Duke and Dauphine Billy Mays

Still alive in the car business

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A Partial List Of Billy Mays’ Pitches

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Some Potential Lemon Principle Items?

Dating servicesOnline educational institutions Overseas adoption servicesAirport cab driversNon-FDA approved supplementsNon-FDA approved cancer cures and foreign

cancer clinicsFranchise business investmentsFractional resort condo sales