Managerial Economics: Topic 1 2 Adverse Selection and Signaling Good s with different quality: Adverse Selection Signaling equilibria Pooling equilibria Mass Markets with quality problems We’re considering mass markets for homogenous goods = everyone produces goods that look the same BUT
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Goods with different quality: Adverse Selection
We’re considering mass markets for homogenous goods
= everyone produces goods that look the same
are not necessarily of the same quality
Used car market:
Sellers and Buyers know whether it’s a good car or a lemon:
Will you buy if the price is at least $8,000? NO!
So we expect that the market will have a price between $3,000 and $6,000, with only lemons sold.
If buyers don’t know whether it’s a good car or a lemon, it’s one price for good or bad.
“a lower price means a lower quality of cars in the market.”
Any evidence of such problems in the used car market?
(Dutta, Strategies and Games)
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”
= works like an improvement in efficiency, but for the wrong reason! (uninformed customers)
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 (one-time) $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 can’t assume the warranty means it’s a good car
What is the purpose of offering a warranty to customers?
How? By offering a warranty that would be unattractive for a lemon seller to offer, even if it convinced buyers!
Key lessons from this case:
Let’s return to our car market example. Currently only lemons on the market, for $6000.
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 they would accept the deal.
Breakdown (zero chance)
Don’t offer deal
No breakdown (100%)
But the buyer can infer that the seller is good
– the seller of a lemon would not offer the deal.
Don’t offer deal
Sell for $6000
No breakdown (20%)
Expected payoff for
lemon seller if buyer
accepts offer is
So the lemon seller
will not offer this deal!
No breakdown (20%)
From Dutta, Strategies and Games:
Example: Back to bargaining.
Spell out exactly what this will mean, in this situation.
= points you to a signal that is cheaper for you to send than them
ex: FedEx versus US Post
This is called “screening”