Managerial Economics: Applying the Tools Topic 10, Part 2 Good s with different quality: Adverse selection Signaling equilibria Pooling equilibria Paul Kerin & Sam Wylie MBS: Term 3, 2004 Mass markets with quality problems We’re considering mass markets for apparently homogenous goods
Goods with different quality: Adverse selection
Paul Kerin & Sam WylieMBS: Term 3, 2004
We’re considering mass markets forapparently homogenous goods
= everyone produces goods that look the same
are not necessarily of the same quality
MASS MARKET CUSTOMERS
The seller knows what type of car she is selling. (This is a generalisation.)
What happens in the market depends on whether buyers can also tell the type of car
The problem of adverse selection can lead to the complete collapse of the market for good cars
Any evidence of such problems in the used car market? (Dutta, Strategies and Games)
Suppose you would pay 80% of new if there were no adverse selection
Asian crisis led to a serious liquidity crisis for many Asian firms
(Inadequate accounting practices, inadequate government supervision, lack of transparency in record-keeping.)
What is the outcome, if insurance companies raise the price of insurance to that group?
Imagine an economy in which the currency consists of gold coins. The holder of a coin is able to shave a bit of gold from it in a way that is undetectable without careful measurement; the gold so obtained can then be used to produce new coins. Imagine that some of the coins have been shaved in this fashion, while others have not. Then someone taking a coin in trade for goods will assess positive probability that the coin being given her has been shaved, and thus less will be given for it than if it was certain not to be shaved. The holder of an unshaved coin will therefore withhold the coin from trade; only shaved coins will circulate.
“Bad Money Drives Out the Good”
Let’s go back to our used car market, and suppose that there are lots more buyers than sellers the price rises to buyers’ WTP
Sellers of good cars want to offer a warranty—but what kind of warranty?
Ex: Let’s say the warranty is a $2000 payment in the event of a breakdown
But if that warranty makes buyers willing to pay close to $10,000 instead of $6,000, sellers of lemons will want to offer the warranty, too
Customers shouldn’t assume the warranty means it’s a good car
Let’s return to our car market example
Suppose that good cars never break down. However, a lemon has a high probability of breaking down (that is why it is a lemon). Say lemons break down with an 80% probability. (But cars only break down once)
Fixing a broken down car is expensive – about $5,000.
Suppose now that a car seller offers you the following deal – “Buy the car for $9,000. If it breaks down, the seller will fix your car for free.”
Should you buy the car?
So if the buyer knew that it was a good car, she would accept the deal
Breakdown (zero chance)
No breakdown (100%)
But the buyer can infer sellers offering the deal are good, the seller of a lemon would not offer the deal
No breakdown (20%)
Expected payoff for
lemon seller if buyer
accepts offer is
So if the lemon seller
thinks that you will
accept the deal,
they will not offer it!
No breakdown (20%)
It applies whenever you need to distinguish yourself from another type of person/firm/group
Example: Back to bargaining.
Spell out exactly what this will mean, in this situation.