The scarcity of information creates the potential for a “market for lemons”. Analyse the market for lemons and the strategies that are available to firms and consumers to overcome this problem
...the average quality. Consequently, buyers perceive that they are not getting ‘value for money’ and there is a to much ‘risk’ involved in a purchase so demand drops. Price then drops to try and raise demand. Owners of high quality machines become unwilling to sell as they cannot realise the full worth of their vehicles. This is a vicious circle and results in bad quality driving good quality out of the market. Eventually, due to the prices being driven so low, the only people willing to sell their cars are the owners of lemons. This causes what is known as an adverse selection problem. This can cause markets to become thin and in some cases nonexistent; economy’s can be left with an “incomplete set of markets”.[Stiglitz, J (1997), P343] Economic Consequences On an economic scale, asymmetrical information leads to “fewer buyers and sellers entering into a market than would be the case with perfect information”.[Stiglitz, J (1997), P434] It drives legitimate business out of the economy causing quality to be reduced and the emergence of an adverse selection problem. This adverse selection problem is the fundamental cause of market failure. Sellers cannot lower prices and so markets can be prevented from clearing. Markets become thin and can evaporate. Only a fraction of potential gains from trade is realised. This is a particular problem in undeveloped countries where information is a scarce resource and there is a large incentive to act dishonestly. Imperfect information has another economic cost. Due to the price dispersion of homogenous goods and the variation in quality of products there is a resultant search problem. The marginal cost incurred by the buyer increases with price dispersion and the time spent searching for products. This search also carries with it an opportunity cost to the economy. Importance of Imperfect Information We live in an “information economy”. [Stiglitz, J (1997), P450] Reuters Magazine reported that during the last thirty years humankind has produced more information than in the previous five thousand. Economists are now beginning to realise the importance of understanding imperfect information and the effect it has on individuals and markets behaviour. The perfect information that is necessary to make markets function in the proper fashion, as indicated by the point of equilibrium demonstrated in the famous Marshallian Cross where supply and demand are equal, is not available. “Imperfect information means that equilibrium will be achieved away from the intersection of supply and demand”.[Stiglitz, J (1997), P437] Economists awareness of imperfect information is helping to bridge the gap between reality and the basic model of perfect competition. Solutions When trying to convince a potential buyer that the product/service your offering is not a “lemon”, “actions speak louder than words”.[Stiglitz, J (1997), P435] Sellers have a number of strategies available that signal to the market the quality of a product or service. It is important that they do this effectively in order to convince consumers of quality and increase their chances of an advantageous outcome. Incentive problems that face firms are tackled by “stipulating penalties and rewards”[Stiglitz, J (1997), P438] using contracts, guarantees and warranties. Reputation is also an incentive for fair-trading. If buyers want to minimise the chance of them purchasing a lemon they need to consult expert advice, effectively search the market and learn how to decipher firms signals. Reputation One of the central economic problems is providing people with the incentive to act morally and in the interests of the market. Firms develop reputations within a market for the quality of their products or service. “A reputation is a form of guarantee”.[Stiglitz, J (1997), P443] The incentive to develop and maintain a good reputation is profit. The development of a good reputation allows firms to successfully raise prices above marginal costs of production. In the model of perfect competition it wouldn’t be possible to realise abnormal profits. Guarantees and Warranties Firms offer guarantees and warranties to eliminate the risk involved in purchasing products; they signal higher quality to potential buyers. Information is not a requisite for the consumer when a warranty or guarantee is offered as this allows the opportunity to fully test the product. If the product proves to be a lemon it can be exchanged. Although this eliminates risk, it does not eliminate bother. Contracts In the service market, contracts between parties specify conditions that have to be met. These contracts include contingency clauses that cover various eventualities and stipulate their consequences. If either party does not uphold their end of the bargain they are said to be in breach of contract. This then becomes a legal matter. Contracts protect people legally. However, they are “incomplete and enforcement is costly”.[Stiglitz, J (1997), P349] The solution they offer is only as good as the lawyer who writes the contract. Advertising As was previously mentioned, imperfect information creates a search problem. Advertising reduces this problem by creating consumer awareness of a products quality and price. Advertising can be both informative and persuasive. Not only does it provide key information about a product/service but advertising can also create a brand image which buyers can associate with. Advertising changes the slope of the demand curve by creating a perception of difference, it also pushes the demand curve out. Information Intermediaries Search costs are further reduced by “information intermediaries”. [Stiglitz, J (1997), P445] These intermediari...