Page 424 - DECO401_MICROECONOMIC_THEORY_ENGLISH

Unit-30: Economics of Information

The Theory of Asymmetric Information Notes

Asymmetric information is such a condition, when a party has more information than the other about a
durable product’s nature, property and others therefore he influxes the result of a deal. It generates the
moral hazards and adverse reflection which is as follows:

Advance Selection: The Lemons Problems

When a party has more information than the other then it creates problem of selection which appears
as surprising result Prof. Akerlof has elaborated giving the result example of the market of old car
in his famous book ‘The market for lemons.’ There are two types of old cars. One is cherries, which are
considered as good. The other is lemons, which are considered bad. Suppose a man purchases a new
car. He is not satisfied by the performance and he wants to sell after a few months later, though this
is good in condition when he tries to sell the car which is like a new then he will be offered a very low
price by the carpeted customer. According to Akerlof, because the prospective customer has developed
asymmetric information that car is not in order. So, the owner of the car is ready for selling it after
buying few months ago. So, he has to sell the old car on the average market price, because in the market
this is a lemon car for the prospective customer. But the car owner knows that his car is cherry which is
like a new one. So, he refuses to sell the car because he is not getting the right price.
This way the owner of old good car (cherry) not sell their cars and only lemon car is being sold in the
market. This is like the Gresham’s law which says that “bad money keeps out good money from the
market”. Thus, it can be said that bad car keeps out good car from the old car market.
Now, we can describe this by an example. Suppose that prospect customer rate 60,000 for a bad car
(lemon) and 1,20,000 for good car (cherry) in the market of old car. There is fifty-fifty chance of good
or bad car for every car in the market. So the customer is ready to average of both type cars price I.C.
90,000 (= 120,000 + 60,000/2). The other ride, the car owner rates 1,00,000 for good car (cherry) and
50,000 for bad car (lemon). This situation creates the problem of adverse selection. There is adverse
reflection situation because the seller has better knowledge than the buyers. It is different to distinguish
the bad car before buying from the market for a customer.
Suppose that the lemon price is between 60,000 and 90,000. Then the owner of good car will not sell
the car because their car price is 1,00,000. Because the bad car seller is getting better price which is
more than the 50,000. They will present to sell their car Resulting, There is no sell for good car. Finally,
the customer feels that the probability of bad car is more. Therefore, in the market of old car price is
60,000 reduced and only bad car will be selling for good car. This is the case of separating equilibrium
which reporter the good cars and bad cars market.
Figure 30.1 describes the problem of the lemon and solution. In figure’s Panel A exhibits the good car
when S is curve of supply and D is curve of demand. Thus, Panel B exhibits S as the supply curve of
B
G
G
bad cars and D of its demand curve.
B
Suppose the old car market is complete informed when the buyer and seller know the quality of cars
which they want to buy and sell. In panel A, the number of good cars is OQ sells on higher price of OP
G G
and in panel B, the bad cars OQ sells on price OP . The customer has no information about the quality
B B
of cars due to adverse reduction from asymmetric information, so the sellers of good cars purposed
the price OP , resulting the demand of good cars fall downs by OP’ as the D curve of demand and
G G G
S supply of curve in show the corresponding point E . figure B exhibits situation of the price OP’ in
G 1 B
increase in demand OQ’ in adverse relation. This price is ready to pay by both buyer and seller. Finally,
B
in the old car market, only bad cars are sold on this price.

LOVELY PROFESSIONAL UNIVERSITY 417