|Angel J. Zapata Rubio|
Today I’m going to talk about market failures, more precisely, about problems raised by differences in information between buyers and sellers.
Usually and for simplicity, economists start studying a market as if the people involved are perfectly aware of everything inside it. All share the same information (They know the quality of the good, the supply, the demand, the price...). An individual is capable of making the right pick whenever faced with two similar goods, and this state is called a perfectly competitive market.
Unfortunately, in real life things don´t work out so easily for everyone. Information is costly to obtain, or in certain circumstances, impossible, so we get to the obvious conclusion that the parties involved in a transaction never, or almost never, (just to be safe) have the same information of the product sold. Normally the seller always has some extra information about the product (since he is more familiar with it, or he is the one producing it), that he may not be interested in sharing with the buyer.
To make the argument clearer, I will proceed with a famous example: The market for lemons (‘’the market for lemons: Quality Uncertainty and the market Mechanism’’, the Quarterly Journal of Economics, 84, 1970, pp. 488-500)
In this example, we have a market with 100 people who want to sell their used cars and 100 people who want to buy a used car. Everyone knows there are 50 plums (good car) and 50 lemons (bad cars). But only the current owners of the vehicles know the quality of their own cars. The owners of plumbs will be happy selling them for 2000, and the owners of lemons, for 1000. In the other hand, the buyers are willing to pay 2400 for the plumbs and 1200 for lemons. If there was no problem knowing the quality of the car, the lemons would be sold at a price between 1000 and 1200 and the plums between 2000 and 2400. But since buyers don´t Know the quality of the car; they will be willing to pay for any car, its expected value
0,5x1200 + 0,5x2400= 1800.
The problem comes when we think about who will be willing to sell their car at that price, the answer is that the owners of the lemons certainly would, but the owners of the plums wouldn´t. In this case scenario, none of the plums get sold, even if the buyers are willing to pay 2400 in the first place.
The source of this market failure is that there is an externality between the sellers of good cars and bad cars. If the owners of bad cars decide to sell them, they will bring a negative impact to the owners of the good cars, since the average of the quality of the cars in the market; together with the price buyers are willing to pay for used cars go down.
In the end, the fact that someone is offering to sell his/her car gives a negative signal about the quality of the car so it makes it really hard to high quality cars to be sold.
This conclusion leads to another economic issue, signalling, which is one way of solving the problem of asymmetric information. Sellers of a particular product will try to demonstrate or prove to buyers how their good is better than the rest.
In the example of cars, the owners of plum cars can offer buyers to test the car before buying it. By doing this they make sure the buyer knows the car is a high quality car, and therefore he will be willing to buy it for the real price of a plum car.
The example of `the lemon market´ can be applied to any competitive market on which firms are competing for quality instead of quantity.
By the way, there is a very funny reference to this lemon market example on the 8th chapter of the 1st season of ‘How I met your mother’ for those of you that like this sitcom.