EC260 Chapter Notes - Chapter 16: Adverse Selection, Life Insurance, Relative Risk

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greenseal220

6 Sep 2016

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The term lemon is used to refer to a used car that turns out to have a lot of problems - used cars with no hidden defects are called gems. A famous paper by ackerlof points out that a disproportionate number of lemons turn up in the used car market - this arises because of the information asymmetry between buyers and sellers of used cars. Sellers have more information about the quality of the car they are selling than the buyer does. Buyers will not want to pay more than the average price in the market. Owners of gems are less willing to sell at the average price because they know that gems are worth more than the average price. Owners of lemons are eager to sell at the average price because they know that lemons are worth less than average price. As a result, most of the used cars on the market become lemons.

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Used car dealers are faced with the following problem. There are two types of used cars: gems and lemons. Buyers are willing to pay $8,000 for gems and $5,000 for lemons. Sellers of lemons want $3,000, while the sellers of gems want a minimum price of $6,000. Half of the cars offered for sale are gems and half are lemons. The sellers know which cars are gems and which are lemons, but the buyers and the dealer do not.

a) Assuming that neither the dealer nor the buyers of used cars can tell a gem or lemon apart, what will gems sell for in the used car market? What will lemons sell for? (You may ignore any costs of operating the used car business beside the costs of cars offered for resale).

b) A test is developed that flawlessly tells a gem from a lemon. The test, which costs nothing, is widely known. Any owner can run the test (though buyers cannot). An owner can easily offer to sell his car enclosing a certified copy of the test. The certification is an infallible sign of whether the car is a gem or a lemon. Assuming that every auto seller provides the test, what would then be the price for gems and lemons?

c) Assume now that the test costs $50. What will happen to the price of gems and lemons?

Adverse selection occurs in the market for used cars because used car buyers:

A) Used car buyers tend to have more accidents that new car buyers

B) Have less incentive to maintain the value of their cars than new car buyers.

C) Have less information than used car sellers.

D) Have more information than used car sellers.

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Incomplete information frequently lowers the average quality of products and services exchanged in markets. This phenomenon, at times called the "lemons problem," explains why the supply of lower-quality products increases relative to higher quality products when sellers cannot communicate the quality of their products to potential buyers. Discuss:

a. Why efficiency in markets with incomplete information present lower than in those with perfect information.

b. How âlemon lawsâ that allow buyers to return used cars or other products that turn out to be âlemonsâ help to correct the problem.

c. How certifications and warranties can reduce inefficiencies.

EC260 Chapter Notes - Chapter 16: Adverse Selection, Life Insurance, Relative Risk

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