The document discusses informational deficiencies in markets that can lead to inefficient outcomes, such as the lemons problem where only low-quality used cars are sold due to asymmetric information between buyers and sellers. It also covers the free-rider problem where the market may underprovide information since it is non-excludable, and search costs that affect how much time consumers spend researching different products and prices.

1. Lemons
May 8, 2013

2. Announcements
• Midterms passed back at end of class.
• Assuming exams passed back this week, come to my
office hours Friday11am-1pm if you think you deserve
regrade.
• Sun God festival next Friday – what should we do?
• Remember, you have two chapters to read for Monday
along with problems
– Start early!

3. Last Class
• Started our conversation on informational
deficiencies.
• Saw that lack of information leads to buyers
and sellers making inefficient decisions.

4. Learning Goals for Today
• Be able to define the free-rider problem using
examples.
• Describe the lemons model and why there are
theoretically only bad used cars for sale.
– At odds with our conclusion last class: Why?

5. How much information?.
Markets that people Markets that people
research before buying. research until MB=MC.

6. Will the Market Provide the Optimal
Level of Information?
• In theory, information could be bought and sold just like any other good or
service.
• BUT because information can be easily transferred from one person to the
next, it’s hard to keep people who don’t pay for information from benefitting
from it.
• Leads to a free-rider problem: any situation in which too little of a good or
service is produced because you can’t exclude people who don’t pay for a
good or service from benefitting from it.

7. Will the Market Provide the Optimal
Level of Information?
• People’s individual willingness to pay for information will be less
than the social benefit of the information (since the information
can costless be transferred to others).
– Similar to the existence of a positive externality
• Markets will provide too little information.

8. Will the Market Provide the Optimal
Level of Information?
• Example: go to Best Buy to learn about HDTVs, then buy online.
– Best Buy covers the cost of the information it provides by
charging a little more.
– If no one willing to pay the extra for a TV from Best Buy, Best
Buy will have a hard time providing good customer service.

10. Show-Rooming
Rise of smart-phones has resulted in consumers
going to individual stores, and then searching
for same product online to find similar prices.
What are some examples?

11. Show-Rooming
Rise of smart-phones has resulted in consumers
going to individual stores, and then searching
for same product online to find similar prices.
What is the ``story?’’

12. Factors That Affect the Marginal
Benefit of Information/Search
• All else equal, people should spend the most time searching
for products and services when
– They are expensive.
– There is a lot of variation in price/quality.
• Examples:
12

13. Some Definitions
• Expected value of a gamble: the sum of the possible outcomes of
the gamble multiplied by their respective probabilities.
• Fair gamble: a gamble whose expected value is zero.
• Better-than-fair gamble: a gamble whose expected value is greater
than zero.
• Risk-neutral person: someone who would accept any gamble that is
fair or better-than-fair.
• Risk-averse person: someone who would refuse any fair gamble
(that is, they’ll only accept gambles that are more-than-fair).

14. Possible Outcomes and
Probabilities
Expected Value
Gamble 1 $10 with probability .5 or
-$10 with probability .5
Gamble 2 $1 million with probability .5 or
-$1 million with probability .5
Gamble 3 $200 with probability .5 or
-$100 with probability .5
Gamble 4 -$100 with probability .5 or
$40 with probability .25or
$400 with probability .25 or

15. Above is information on Jeans. Given your job pays $10/hr, what is the most
time you should you spend in the store looking for an ``awesome’’ pair,
rather than just grabbing a random one off the rack?
A. 30 mins
B. 1 hour
C. 1 hour 3 mins
D. 2 hours
Value Cost Probability
“Okay” $80 $80 0.50
“Awesome” $100 $80 0.50

16. Search & Commitment Problems
• Imperfect information means that potential trading partners may fear that
some better opportunity will come along.
– This can make people reluctant to commit.
– Otherwise productive exchanges may not take place.
• People find ways to commit themselves to remaining in the relationship.
– Employment contracts
– Rental agreements (year-long lease)
– Return policies
• The claim: “it’s easier to get married than divorced”.

17. Asymmetric Information
• Asymmetric information: situations in which buyers and sellers are
not equally well-informed.
• Examples:

18. Last Class: Your reservation price for a good used
car is $5000. For a lemon is $1000. Given 20% of
all cars are lemons, we can predict that
A. only lemons sell, for $1k each.
B. both types of cars sell, for $4200 each.
C. only good cars sell, fro $4200 each.
D. both reliable cars and lemons will sell for $1k
each.

19. The Lemons Model
• If buyers are risk neutral, they should be willing to pay $10,000.
• But then people with good cars won’t sell their cars . . .
Sellers’
Reservation
Price
Buyers’
Willingness
to Pay
Probability
of Each Type
of Car
Good car $11,000 $12,000 .5
Bad car (lemon) $7,000 $8,000 .5

20. • All cars in the market will be bad cars.
• Last class we said both cars sell for expected value given the buyers’
decision, but we didn’t take account of sellers’ decision.
• Inefficient because some mutually beneficial exchanges will not
occur (good cars are never bought and sold even though they
should be).
Sellers’
Reservation
Price
Buyers’
Willingness
to Pay
Probability
of Each Type
of Car
Good car $11,000 $12,000 0
Bad car (lemon) $7,000 $8,000 1

21. 0
5
10
15
20
25
30
35
40
0 to 10 11 to 20 21 to 30 31 to 40 41 to 50 51 to 60 61 to 70 71 to 80 81 to 90 91 to 100
A’s
B’sC’s
Less than C
Max: 99
Min: 10
Avg: 63