Download Industrial Economics

Industrial Economics
Fall 2008
INFORMATION
• Basic economic theories: Full (perfect)
information
• In reality, information is limited.
• Consumers do not know which store sells a
good at the lowest price or how quality varies
across brands.
• The limited information has important
implications on the market structure.
Limited Information about Quality
• Consumers frequently do not know how
quality varies across brands in markets for
services of professionals ( e.g. Doctors,
lawyers, electricians, economists), processed
foods, used goods, complex mechanical or
electronic products.
• There is asymmetric information: One party to
a transaction knows a material fact that the
other party does not.
• Seller knows the quality of the good but buyer
does not.
• Result of asymmetric information about
quality:
1. An equilibrium may not exist.
2. If an equilibrium exists, resources are used
less efficiently than they would be if there
were symmetric, perfect info.
• The classical analysis of Nobel prize winner
George A. Akerlof (1970) is probably the bestknown study about the limited information
and its effect on the market.
Akerlof, A. G. (1970) The market for“Lemons”:
Quality uncertainty and the market mechanism, The
Quarterly Journal of Economics, Vol. 84, No. 3, 488500.
• Akerlof shows that, where sellers have perfect
information and consumers have extremely
limited information, a market may not exist or
the lowest quality good may be sold.
• Example: Consider a used car market.
The seller (current owner) has learned over
time whether the car rarely needs repairs (a
good car) or frequently needs them ( a
“lemon”).
However, at best, a potential buyer knows the
probability of getting a good car.
If buyers cannot distinguish between a good and
a bad used car, the cars will be sold for the same
price.
Hence, if both bad cars and good cars are sold at
the same price: Bad cars are overvalued and
good cars will be undervalued in this market.
• Suppose that, consumers believe that half of
the cars sold in this market are “lemons” and
they value those cars at $100 and half of them
are good cars which are valued as $200.
• If consumers are risk neutral, the value of a
randomly selected car to a typical consumer:
EV(C)=0.5(100)+0.5(200)=150
• The buyer is willing to pay more than the
value of a bad car, since in that case the car
may be good but not willing to pay the full
value of the good car since the car may be a
“lemon”.
• In such a market, bad cars will drive out good
cars. Why?
• Owner of a bad car is delighted to sell the bad
car for more than its worth but the owner of
the good car would not want to sell his car for
less than its value and keeps his car.
• In a market where only two types of cars are
sold, only bad cars will be sold. As a result,
buyers know that they are getting lemons and
they will pay only for the lemon: $100.
• This has also implications in other fields:
E.g. Insurance industry – Health insurance case
The price of health insurance increases with age
because older people are more likely to need
health insurance. Since price is too high, healthy
old people would not find it attractive. Only
worst risks buy the policy.
This leads to the “adverse selection” problem.
• Another implication of the asymmetric
information and adverse selection is “moral
hazard”. Moral hazard arises because an
individual or institution does not bear the full
consequences of its actions and therefore has
a tendency to act less carefully than
otherwise. It leaves another party to bear
some responsibility for the consequences of
the actions.
• E.g. An individual who has a car and insurance
If he/she behaves leass carefully to lock the
car, as a consequence theft may occur.
Insurance firm bears the responsibility.
• Also asymmetric information lowers quality.
This leads to inefficiency when compared with
markets of perfect information.
• Due to asymmetric information, if a seller
provides a high-quality product, he cannot
capture the complete benefit of selling a highquality product.
• When a seller provides a relatively high quality
product, average quality in the market
increases.
• Buyers are now willing to pay more for all
goods .
• Hence, high quality seller shares its benefits
with sellers of lower quality products.
• Since cost of producing higher quality
products is greater than the price of the
average quality products: A firm will be willing
to produce and sell a low quality product.
Limited Information about Price
• If there is full information in a market, if one
store raises its price above the level of others,
store loses all its business.
• If consumers have limited information about
price, now a store can raise its price without
losing all its sales. This time, store faces a
downward sloping demand curve and has
some market power.
• Tourist trap model:
Linda is a typical tourist. She goes to Florence
and wants to buy a souvenir (a mug). She does
not have much time to search for alternative
prices since the tour will leave soon. She has
limited info. If there are many such tourists,
what prices do the stands charge for these
mugs?
• Diamond, P. (1971). A Model of Price Adjustment. Journal of
Economic Theory 3(2):156-168.
• Assumptions:
• _ N firms sell a homogeneous good with constant and
identical marginal cost (MC). Firms set prices for the
homogeneous product (Bertrand game).
• _ Consumers know the distribution of prices but not the price
at specific store (limited information).
• _ Consumer can learn the price of a particular store, but this
costs the consumer a search cost of c for each store they learn
the price of.
• Is the marginal cost pricing still a Nash equilibrium with
limited information/search costs?
• Full information equilibrium: P=MC : Pc
• A deviant firm may charge: P*=Pc+ e e: price markup
• Suppose that Lisa goes to a stand that P=P*. She knows from
the guide that this is somewhat higher than Pc but she should
also consider the cost of visiting another stand.
• If P*<Pc + c ( c: search cost) : e < c : She does not go to
another stand.
Conclusion: A deviant stand can raise its price by
an amount less than the cost of search. As a
result, marginal cost pricing may no longer be
a Nash equilibrium when consumers have
limited information about price and there are
positive search costs.
Hence, what is the equilibrium price?.
• Is it P*? No. It can be broken by P**=Pc+ 2e
• Is it Pm? If there is a single price equilibrium, it can
be only at Pm. At prices below Pm, firms have an
incentive to raise prices.
• Can Pm be broken?
• Yes.
• 1. Suppose there are two firms, and both of them
initially set price at the monopoly level. If a firm
lowers its price by an amount less than the search
cost, consumers have no incentive to search for the
lower-price firm. If one firm lowers its price by an
amount greater than the search cost, all consumers
will buy from that firm with the lower price (and this
price may be greater than the marginal cost).
Any consumer who first arrives at the expensive
store will be willing to incur the cost of going to the
other store to find a lower price. If there are small
number of firms, it pays a deviant firm to lower its
price by an amount greater than the search cost. This
firm can have a higher profit by doing so due to an
increase in sales volume even though it makes less
per sale than the higher-price firm.
Result: Multi-price equilibrium.
• 2. For large N, the number of firms: If there are 100
firms and all of them set price at the monopoly level,
it is no longer clear that a single firm would profit by
lowering the price by more than the search cost. This
is because consumers still do not know which firm
has the lower price, they just know there is one firm
out there somewhere. So consumers will tend not to
change from the first store they arrive at and find the
store in which the monopoly price is offered.