Imperfect Information and Disappearing Markets Imperfect Information and Disappearing Markets A mixed market is a market where low-quality goods and high-quality goods are mixed together.
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A market will break down, or the high-quality goods will tend to disappear, if either buyers or sellers are unable to distinguish between low-quality goods and high-quality goods.
Asymmetric information occurs when one side of the market – either buyers or sellers – has better information about the good than the other.
If buyers cannot distinguish between lemons (low-quality cars) and plums (high-quality cars), both will be sold together in a mixed market for the same price.
In such a market, the odds of getting a plum are small. The high-quality goods will tend to disappear and, in the extreme case, will be completely nonexistent.
The minimum price for plums is $2,500. At any price less than $2,500, no plums will be supplied
The minimum price for lemons is $500. No lemons will be supplied at any price less than $500.
At a price of $2000, only lemons will be supplied (9 lemons, as show by point p).
At a price of $3000, the supply of lemons is 16 (point m).
Adverse selection is the result of the dynamics of asymmetric information (one side has better information than the other), which generates a downward spiral of price and quantity
The market is in equilibrium because consumers accurately assess the chances of getting a lemon.
At an equilibrium price of $2,200, 20 cars are sold, 10% of which are plums.
The supply of lemons at this price is 18 (point t)
The actual chance of getting a lemon is 90%, the same as the assumed chance of getting a lemon.
Suppliers can identify a particular car as a plum in a sea of lemons by offering a guarantee:
A vehicle repurchased under the lemons law must be fixed before it is sold to another customer and must be identified as a lemon.
A problem with enforcing these laws is that lemons can cross state lines without paper trails. New interstate commerce laws requiring the branding of cars as lemons on vehicle titles have been established.
This happens because of asymmetric information and adverse selection. The new team has much less information than the old one.
Insurance companies must pick from an adverse or undesirable selection of customers. Buyers of insurance policies have more information than sellers.
The mixed market increases the cost of providing insurance and the price of the malpractice policy.
Most insurance companies now use experience rating—a price based on the medical history of the firm’s employees (a different price for each firm).
Insurance causes people to take greater risks. They don’t buy a fire extinguisher, or tend to drive recklessly. These are unobserved actions that increase the probability of a grim outcome.
The moral hazard is pervasive. The availability of insurance, for example, decreases investment in prevention programs that reduce risk.