The Economics of Business CLASS 15 TALKING POINTS
Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Bradley Holland
Dilemma of Buying 2
Verifying quality is a long time problem; ¡
Archimedes (~287-212BC) and the gold content of crown for Hero II of Syracuse
¡
Famous “eureka” moment in tub and streaking through town Method described in historical lore probably wouldn’t work (see for example:http:// www.math.nyu.edu/~crorres/Archimedes/Crown/CrownIntro.html)
Counterfeiting was a capital offense in ancient Rome
Ancients relied heavily on severe after-the-fact penalties ¡
Hammurabi code (~1772 BC) on building defects: “If a builder has built a house for a man, and has not made his work sound, and the house he built has fallen, and caused the death of its owner, that builder shall be put to death.”
Modern societies implement many before-the-fact licenses, certifying
agencies, building codes, etc. Caveat Emptor good advice but unclear legal role “Don’t look a gift horse in the mouth” – not entirely rational Implied warranties relatively recent legal innovation The “lemon principle” still very relevant
George Akerlof 3
Won 2001 Economic Nobel Prize largely 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
Akerlof’s Used Car Market 4
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 what q is 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 and even the average quality cars, leading ultimately to collapse
Trader Types 1 and 2 5
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
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 10
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)
Symmetric Information Case, continued 11
The aggregate demand curve, Dp
Undefined?
Supply Curve for the Symmetric Information Case 12
Supply, S, in the symmetrical information case is a 2 part function depending upon whether p>1 or p