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[ECON 101] - Midterm Exam Guide - Comprehensive Notes for the exam (37 pages long!)


Department
Economics
Course Code
ECON 101
Professor
Richard Coe
Study Guide
Midterm

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VCU
ECON 101
MIDTERM EXAM
STUDY GUIDE

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Asymmetric Information
Thoughout the seeste, hile e hae’t ee e epliit aout it, e hae ee assuig that
both buyers and sellers in a market have the same information about the quality of the products they
have been buying and selling.
However some situations arise where the buyers and sellers have asymmetric information one party
knows more about the quality, say, of a good that is being sold. The classic example is a used car. The
seller of the used car knows more about the car than the potential buyers. They know if the car is a good
a a plu o a ad a a leo.
What ae the ipliatios of aseti ifoatio? Let’s see.
Suppose buyers are willing to pay $4000 for a plum and $2000 for a lemon. Suppose buyers assume that
if they buy a car, there is a 50/50 chance they will get a plum, a 50/50 chance they will get a lemon.
Without knowing what type of car they will get, they might be willing to pay perhaps $3000 for a used
car.
No, suppose ou’e sellig a a. You see the going price for used cars is $3000. Are you more likely to
offer your car up for sale if it is a plum or if it is a lemon? $3000 is a good price for a lemon, but not such
a good price for a plum. Other owners of cars would be making similar calculations. When you go out
ad look at the tpes of a that ill e o the aket at this pie do ou epet that thee ill e a
equal number of plums and lemons? Not so. In fact, we would expect a large number of lemons and just
a few plums (if any). Lemon owners will jump at this price, while plum owners will be less willing to sell
their cars. Perhaps it will be an 80% lemon, 20% plum split. This is called adverse selection. The cars
available for sale on the used market will be an adverse group (disproportionately lemons).Will
consumers (who thought they had a 50% chance of getting a plum) be willing to pay $3000 now? Now
there is an 80% chance they will end up with a lemon and only a 20% chance they will end up with a
plum. Since there is a smaller chance they will get a good car, the price they will be willing to pay will
fall, say to $2400. This price will fall may further exacerbate the adverse selection problem at a price of
$2400 even more plum owners to hold back their cars for sale. Eventually, it could get to the point that
nearly all of the cars on the used markets will be lemons.
“o hat’s the poit? With aseti ifoatio aout the ualit of as, e ould epet a
disproportionately large number of lemons in the market for used cars. The lemons drive the good cars
out of the used market. The used cars for sale are an adverse selection (of all used cars).
How do we solve the problem?
How do owners of plums convince sellers that they have a plum? How about offering a money back
guarantee? Or a warranty where you agree to pay for repairs?
Sellers of a lemon would not find these options desirable. While the seller would receive the plum price,
buyers would realize the car is a plum. The owner would have to pay for the repairs or give the money
back to the consumers.
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How about paying for expert information? You could have an expert, in this case a mechanic, take a look
at the car and try to determine the quality. Often people log (and keep receipts)for regular maintenance
for the car. You can call up carfax and see if the car has been involved in an accident. In this case, folks
are actually literally searching for information to reduce the asymmetric information problem.
Information is valuable.
Can reputation (brand names) solve the problem?
You could go to a used car dealer who has a reputation at stake. If this dealer sells a bunch of lemons at
high prices (claiming they are plums), soon everyone around town will know he is a disreputable dealer.
Might this be why people who buy cars from strangers through the newspapers seem to often end up
with crappy cars? Does a one-time seller of a used car in the newspaper have a reputation at stake?
If ou thik aout this futhe, it does’t ake sese to adetise uless ou ae a high ualit selle. “ay
you advertise that you sell only plums on your used car lot. If you do in fact to do, consumers will find
plums and be willing to pay high prices for cars. The money that is spent advertising can be thought of as
investment in reputation. If you continue to sell high quality cars, this investment is effective.
However, if you advertise and produce low quality goods, consumers will realize and stop buying cars
from you. The money you have spent on advertisement is no longer valuable. Advertising then, can be a
signal to potential consumers that you are a high quality producer.
The same goes with signs and Chinese restaurants. The nature of the restaurant business is that it is
reasonably easy to close a restaurant in one place and start a new restaurant another place. So why do I
like to eat at Chinese restaurants with big signs outside the restaurant?
If the Chinese restaurant has a big sign that has the name of their restaurant and the address on the
sign, I know that this sign has no value if they go out of business and try to set up a new restaurant
down the road.
The sign is an investment in their name brand, and it is specific to the address and the name of the
restaurant. If they start serving awful food, that sign is no longer valuable. Whatever money was spent
on the sign is lost. Given that, would a firm that was a fly by night operation, expecting to be out of
business in 3 months, choose to spend $6000 on a fancy sign? No.
Those firms that are spending on signs are signaling quality, as again, it makes no sense to invest money
in a low quality reputation. Therefore, you should avoid restaurants with cardboard signs in the
windows. The more expensive the sign, the better, the more specific it is to the current location, the
better it is. Might this be why banks usually have super fancy lobbies?
Other examples of where reputation is important? Ebay (why have the system of seller ratings?),
Lawyers?
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