The Economics of Business

1. The Economics of Business Class 14 Outline Harvard Extension School Fall 2011 Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

2. George Akerlof Won 2001 Economic Nobel Prize for 1970 QJE article: “The Market for "Lemons": Quality Uncertainty and the Market Mechanism” Not accepted immediately nor adopted widely for several years: “ a struggling attempt…” Now a mainstay of understanding how asymmetric information may distort or damage markets A structure for analysis of “economic costs of dishonesty” Another case of divergence of social and private costs Concept is useful in exploring opportunities for information-producing or sharing products

3. Akerlof’s Used Car Market Buyer has a notion that he has q probability of buying a good quality car; and (1-q) probability of a “lemon.” Buyer cannot discern individual quality but has an idea of q Buyer must assume all used cars are average quality and is only willing to pay that price As a consequence, sellers of above-average vehicles tend to withhold them, sellers of below average vehicles tend to offer them A destructive dynamic ensues in which q declines, expected average quality drops, even fewer good quality vehicles are offered…. Eventually the lemons may drive out the cream puffs

4. Trader Types 1 and 2 • Akerlof defined the demand, Qd, for used cars as function of price, p, and average quality of cars, μ • Qd = D(p, μ) • Average quality, μ, is a function of price, p • μ = μ(p) • Supply, S, is a function of price, p • S = S(p) • Equilibrium: supply equals demand • D(p, μ) = S(p) • Begin by defining traders’ utility functions

5. Table of Utilities for Traders Types 1 & 2

6. Utilities for Trader Groups 1 and 2

7. Relationship of Price and μ

8. Asymmetric Information Case

9. Symmetric Information Case With symmetric information, the constraints due to ignorance and uncertainty are removed Table shows demand curves for two price ranges and the total (last column)

10. Symmetric Information Case, continued The aggregate demand curve, Dp Undefined?

11. Supply Curve for the Symmetric Information Case Supply, S, in the symmetrical information case is a 2 part function depending upon whether p>1 or p<1

12. Symmetric Information Supply and Demand Combining the supply and demand curves

13. Examples of Lemon Principle • Medical Insurance • Geezers find it difficult to buy medical insurance • Government mandate to sell to pre-existing conditions creates a moral hazard (geezer has the asymmetric information advantage) • Remedy is to require all to buy • May be constitutional issues

14. Examples of Lemon Principle, continued • Minority qualifications and hiring • Minority status may be a fairly accurate indicator of educational quality in U.S. • School policies of social promotion and grade inflation erode value of high school degree • Employers cannot easily distinguish among top, middle and bottom of high school graduates • Special efforts to improve quality of minority education and reestablish standards may raise the perceived average quality

15. Examples of Lemon Principle, continued • Dishonesty • Some merchants may exploit asymmetric information to lie about the quality of their goods • Even if some merchants are honest, the buyers may not be able to distinguish the honest from the liars and so shun the market • In this case, the loss is not only lost sales by the crooks but loss of businesses by the honest merchants • In some cases, the government or an industry group may need to vouch for quality, particularly in underdeveloped countries

16. Credit Markets in Undeveloped Countries • Commercial banks in undeveloped countries may not be able to distinguish credit worthiness • Local moneylenders exploit the banks’ ignorance and charge very high rates • Similar things happen in poorer neighborhoods in the U.S. (paycheck loans from Legbreaker, Kneecapper, and Knuckles Bank) • Micro credit has filled part of the void, risk management by group responsibility

17. Counteracting the Lemon Principle Independent information sources, e.g. VEHIX, Carfax, Emily’s List Awards, e.g. Nobel Prizes Government standards, e.g. Appellation d’OrigineControlées (AOC) and Vin de Pays (VDP) Warranties and guarantees, e.g. Hyundai

18. Pitchmen • Grand American Tradition • Duke and Dauphine • Billy Mays • Still alive in the car business

19. A Partial List Of Billy Mays’ Pitches

20. Some Potential Lemon Principle Items? • Dating services • Online educational institutions • Overseas adoption services • Airport cab drivers • Non-FDA approved supplements • Non-FDA approved cancer cures and foreign cancer clinics • Franchise business investments • Fractional resort condo sales