Welcome to week 10 of the power market's course. What we'll do this week is look at certain information imperfections, and how those can lead to some pricing power opportunities and some inefficiencies in markets, and what are some potential mechanisms that at least partially can mitigate the inefficiencies. We also cover a series of applications on monopoly and then we'll turn to input markets, and start on the basics there. For those of you that are following along in the text, we'll basically finish up the remainder of chapter 14, cover a good portion of chapter 15, and the first two sections of chapter 16. In this section, in this session, we're going to cover asymmetric information. What happens when one side of the market has more information than the other? And in this particular session, we'll focus on where sellers have more information than buyers. A great case involves the sale of used cars where sellers generally know if their car is a lemon or a gem, when they're putting it on the market. What kind of outcomes maybe we expect? And one prediction is that we end up with an overabundance of lemons in the marketplace. We'll see why symmetric information can lead to this, and what are the market mechanisms that at least partially can mitigate the lemons problem. And we also then look, it's not just used car markets, but even when you think about applying to colleges, sellers generally have more information about what they're providing the services, the quality of instruction, the dorms than you do although there are some market mechanisms you can rely on and visits to acquire information about one college versus the other. Or when you're hiring a plumber or a contractor, similar lemons problem may prevail. Or when you're hiring an individual employee, where he or she may know more about their capacity and their talents versus the buyer of the market. So, let's first turn to an example, the used car market, and let's assume that there are 50,000 cars being sold that are gems and 50,000 that are lemons. And the gems would sell for $12,000 each, whereas the lemons would sell for 6,000. Now with perfect information on both sides of the market, it wouldn't be a problem. Buyers could figure out what were the lemons and what were the gems, and pay accordingly: 12,000 for the gems and 6,000 for the lemons. Say we didn't know, and say there were 50,000 of each type of car initially being sold. Now a buyer might make an initial assumption that if there's a mix of both cars, that the price would end up being an average of 9,000 per car. And yet, when you think about it, with imperfect information, that might not be a correct assumption. Why? Because if you're an owner of the gem, and there's a $9,000 price that you can sell the gem for formerly with perfect information you could sell for 12,000, you're going to be less likely to put your gem on the market. Analogously, if you're the owner of a lemon, you're going to be more likely to put a lemon on the market when the price settles in at 9,000 of an average than when formerly with perfect information you can only sell the car, the clunker, for 6,000 a piece. So let's assume that instead of a 50 50 percent mix of the two, we're more likely to get 75 percent of the clunkers or the lemons and 25 percent of the gems, and that the price would end up at 7.5 thousand. Reflecting the mix, the three quarters of the cars are lemons and one quarter are gems. Again, there would be a market response. As the price falls, you're less likely to get either gems or lemons supplied because the prevailing price is lower than it used to be of 9,000, but the proportion will keep tilting more and more toward the lemons as opposed to the gems because at an even lower price, it's still attractive for lemon owners to put their cars in the market. It's less attractive than at 9,000 for the gem owners to put their cars on the market. Where will this process end up? It's entirely conceivable that we'll just end up with lemons being sold in the market. With asymmetric information on the lemons problem at work, bad products tend to drive out good products. One other way that this problem is commonly called is Gresham's Law, that when you have asymmetric information and it's after an English policy maker who first observed this phenomenon of bad money driving out good money, where the quality could differ across the coins that were minted in England. Now there are forces at work in the market to alleviate, to deal with the lemons problem. Among the sellers can offer guarantees or warranties, liability laws also work to mitigate. And since there are gains from acquiring information, consumers have an incentive to look at an individual car before they make a purchase, to bring along a mechanic to test it out. There are also market forces like repetition. There are firms nowadays such as Auction Direct that rely on repeated sales of used cars to build up a reputation that the buyers can rely on that make sure that the cars that they're getting are of high quality. So there are a variety of mechanisms, but each of these mechanisms, there's some costs associated, it may not work perfectly. Jim Lacko of the Federal Trade Commission, a number of years ago looked at what extent the lemons problem is at work in the used car market. And he asked buyers simply to rate the cars that they bought on a 1 to 10 scale, where 10 was a gem, one was a lemon. And he looked at different ages of cars, different mileage that they've been driven, and whether the buyer acquired the car from a used car merchant, from a friend or relative, or from an online ad, from somebody that they didn't know. And what he ended up finding for cars between one to seven years old, there was no appreciable difference between the various sources of supply and how buyers rated their cars. So buying it from somebody unfamiliar produce the same rating as buying it from somebody you know, or from a used car merchant. Beyond seven years, there was a difference of about one point if you bought it from somebody unfamiliar, you were one point less happy on a 10-point scale with the car you bought. So it does seem like there is to a certain extent market, there are to a certain extent market forces that mitigate the lemons problem for one to seven years, the average rating overall was at 6.61 on a ten-point scale across all purchases. And the difference only showed up beyond seven years of a point between buying it from a car from somebody that you're not familiar with versus somebody that has a way to build up a reputation or somebody that you're connected with. Now we see other applications where market forces promote good behavior by sellers. A great example is eBay, which is now a $10 billion business. In 1995, its revenue was zero. In 99 percent of the time, buyers rate the sellers that they deal with, who usually they've never dealt with before individually, as being excellent. Why might this outcome occur? Because there's imperfect information between buyers and sellers and sellers who are better informed about the product they're putting up for sale on eBay. Well eBay's developed a reputational mechanism, a way for buyers to rate sellers. Over half the time, buyers fill out the form and indicate the job the sellers done and the quality of the product. That way of keeping score, the repetition of the marketplace that prospective buyers can then access has incredible value to promote good behavior when it comes to eBay. And a study's also recently shown that sellers that have acquired a good reputation, when they promote future sales, they can charge roughly 7.6% more for their products. Reputation also has a good value to sellers. One other, so we've covered the is there lemons problem in used car markets, the Lacko study. One other way that sellers can indicate their higher quality is called signaling. And this was a concept first developed by a former dean at the Stanford Business School, Michael Spence, who won a Nobel Prize for this idea. And he basically argued in a case where buyers don't know if you are a high quality hardworking laborer versus somebody who's less high quality. It may pay to undertake certain investments, certain costly investments than in and of themselves have no value, but still allow you to signal that I'm a type A worker as supposed to a type B. And one of the settings that this model has been applied to is the higher education market. Perhaps applying to an MBA that even if the MBA has no value directly through the education, merely by getting into a high quality MBA program like Stanford or the Simon Business School will allow somebody to indicate that I'm a Type A type worker to a prospective employer. Now one of Spence's colleagues, Jeff Pfeffer also at the Stanford Business School has joked that once you get accepted to a top tier school, that means you shouldn't go, because the higher education of the MBA market business schools have served all the value to you that they can. All you have to do is take that admissions letter to the employer you want to work for. We at Simon disagree, but there is also significant value from the education derived from an institution, and I think the Pfeffer comment has to be taken as a nice quip but not accurately describing the full value of an MBA education.
