Imperfect Informationand Disappearing Markets • A mixed market is a market where low-quality goods and high-quality goods are mixed together. 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.
The Mixed Market for Used Cars • In the model of supply and demand, the efficiency of markets is based on the assumption that buyers and sellers are fully informed. Asymmetric information occurs when one side of the market – either buyers or sellers – has better information about the good than the other.
The Mixed Market for Used Cars 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.
Ignorant Consumersand Knowledgeable Sellers • To determine the price in a mixed market we must answer these questions: • How much is the consumer willing to pay for a plum—a high-quality car? • How much is the consumer willing to pay for a lemon—a low-quality car? • What is the chance that a used car purchased in the mixed market will be a lemon?
Market for Used Cars • If buyers have neutral expectations (assume that there is a 50% chance of getting a lemon), they are willing to pay $3,000 for a used car.
Market for Used Cars 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.
Market for Used Cars • At a price of $3000, the supply of plums is 4 (point n).
Market for Used Cars 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).
All Used Cars are Lemons • When consumers’ expectations are consistent with their actual experiences, the equilibrium price of used cars is $2,000, and the plums will disappear from the market.
Equilibrium in the Mixed Market • The domination of the used-car market by lemons is an example of the adverse-selection problem. The quality of the goods left in the market is adverse, or undesirable. 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
Thin Market for Plums • It is possible that asymmetric information generates a thin market—one in which some high-quality goods are sold, but fewer than would be sold in a market with perfect information.
Thin Market for Plums • If the chance of getting a plum is 10%, buyers are willing to pay $2,200 for a used car. 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.
Thin Market for Plums • If buyers assume that there is a 90% chance of getting a lemon, they are willing to pay $2,200 for a used car.
Thin Market for Plums • At this price, the supply of plums is 2 (point s). 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.
Money-Back Guaranteesand Warranties • The large gap between the willingness to pay and the willingness to accept provides clever entrepreneurs a profit opportunity if they can persuade skeptical consumers that a car is a plum and not a lemon. Suppliers can identify a particular car as a plum in a sea of lemons by offering a guarantee: • Money-back guarantee: The seller offers to refund the price of the car if it turns out to be a lemon. • Warranty and repair guarantee: The seller offers to cover any extraordinary repair costs for one year.
Lemons Laws • Lemons laws require automakers to buy back cars that experience frequent problems in the first year of use. 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.
Used Baseball Players • Baseball pitchers who are more prone to injuries tend to switch teams more often than pitchers who aren’t. This happens because of asymmetric information and adverse selection. The new team has much less information than the old one.
Malpractice Insurance • A person who buys an insurance policy knows much more about his or her risks than the insurance company. Insurance companies must pick from an adverse or undesirable selection of customers. Buyers of insurance policies have more information than sellers.
Malpractice Insurance • Careful physicians do not buy malpractice insurance because insurance companies are unable to distinguish between careful and reckless doctors. The mixed market increases the cost of providing insurance and the price of the malpractice policy.
Pricing Health Insurance • Until recently, insurance prices were based on a community rating—a price equal to the cost of providing coverage to the community or metropolitan area (every firm pays the same price for medical insurance). 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).
Moral Hazard • Moral hazard is a situation that encourages risky behavior. 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.