Industrial Economics

1. Industrial Economics Fall 2008

2. 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.

3. 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.

4. 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.

5. Result of asymmetricinformationaboutquality: • An equilibriummay not exist. • If an equilibriumexists, resourcesareusedlessefficientlythantheywould be ifthereweresymmetric, perfectinfo.

6. The classical analysis of Nobel prize winner George A. Akerlof (1970) is probably the best-known 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, 488-500.

7. Akerlofshowsthat, wheresellershaveperfectinformationandconsumershaveextremelylimitedinformation, a market may not existorthelowestqualitygoodmay be sold. • Example: Consider a used car market. The seller (currentowner) has learnedover time whetherthe car rarelyneedsrepairs (a good car) orfrequentlyneedsthem ( a “lemon”).

8. 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.

9. 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

10. 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?

11. 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.

12. This has alsoimplications in otherfields: E.g. Insuranceindustry – Healthinsurancecase Theprice of healthinsuranceincreaseswithagebecauseolderpeoplearemorelikelytoneedhealthinsurance. Since price is toohigh, healthyoldpeoplewould not find it attractive. Onlyworstrisks buy thepolicy. Thisleadstothe “adverseselection” problem.

13. 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.

14. 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.

15. 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 high-quality product. • When a seller provides a relatively high quality product, average quality in the market increases.

16. 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.

17. 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.

18. 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?

19. 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.

20. 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.

21. 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.

22. 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.

23. 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).

24. 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.

25. 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.