Free rider problem--a common element in this and the previous chapter--relates to tragedy of the commons; an incentive problem in which too little of a good/service is produced (or protected) because nonpayers cannot be excluded from using it.

The efficiency of the invisible hand presumes perfect information.

But information is never perfect.

Also, it is almost always costly.

People should gather information as long as the marginal benefits exceed the marginal costs.

Sometimes they take short cuts, engaging in "statistical discrimination"--they attribute to people or things the characteristics that are "average" for people or things with similar characteristics. E.g., if you are a woman, you have a higher likelihood of taking time out from career to raise a family; if you are an adolescent male, you have a higher likelihood of crashing a car; if you are a Toyota, you have a higher likelihood of not breaking down.

"Middlemen" or services like EBay provide a valuable service of making information available.

Asymmetric information--there's a difference between what buyers and sellers know.

The market for used cars is a good example of a "lemon" problem: cars that are less reliable are the ones most likely to end up in a used car lot. The used car dealer may have this information, but no incentive to share it.

Credibility and signaling--efficiency can be improved by improving trust

The expected value of a gamble--the sum of the possible outcomes multiplied by their respective probabilities.

A fair gamble--a gamble whose expected value is zero.

A better-than-fair gamble--a gamble who expected value is positive

Risk neutral--acceptance of any gamble that is fair or better

Risk averse--refusing a fair gamble

Ignorant--wasting money on unfair gambles.

The Massachusetts lottery is NOT a fair gamble. It is designed to raise revenue. About 30 cents on every dollar goes to the state, and they are now planning to cut this on the theory that most people who buy lottery tickets won't notice or won't care. It's like a tax on ignorance.

Adverse selection--those most likely to buy insurance are those most likely to need it. Another example of adverse selection--blood donation.

Asymmetric information: when buyers and sellers are not equally informed about the characteristics of goods and services for sale.

Example: the owner of a used car knows that the car is in excellent condition, but the buyers cannot know this, and have no incentive to believe the owner when he assures them of its quality....

Asymmetric info can reduce the average quality of goods offered for sale.

Economist George Akerlof calls this "the lemon problem."

Buyers know that cars on the used car market are more likely to be "lemons" than those not for sale.

Hence the price buyers will pay falls (i.e. their reservation price falls).

Prices of used cars will be lower than if there was perfect information.

Hence, owners of cars that are in good condition have an incentive to keep them rather than sell them for less than they are worth.

This causes the average quality of used cars to decline even further.

Homework problem 12.2--some hints.

Consumers know that some fraction x of all new cars produced and sold in the market are defective. The defective ones cannot be identified except by those who own them. Cars do not depreciate with use. Consumers are risk-neutral and value non-defective cars at $10,000 each. New cars sell for $5,000 and used ones for $2,500. What is the fraction x?

Since consumers value non-defective cars at $10,000, the only used cars for sale will be defective ones. The used car price of $2,500 is thus the value to consumers of a defective car. For a risk-neutral buyer, the reservation price for a new car will be the value of a good car times the probability of getting a good car, plus the value of a bad car times the probability of getting a bad car.

By way of review, consider the following multiple choice questions:

The optimal amount of information to acquire before making a purchase is

a) zero

b) as much as technically possible

c) the amount where the total cost of acquiring the information equals the total benefit

d) independent of the expenditure to be made

e) the amount where the marginal cost of acquiring information equals the marginal benefit

the correct answer is e

Tom goes to the local stereo store to learn about high-end equipment. The salesperson spends an hour talking with Tom and demonstrating equipment. Tom then leaves and orders the system he liked from an Internet store and saves $250. Tom is a(n)

a) smart shopper

b) jerk

c) free rider

d) example of adverse selection

e) example of statistical discrimination

The correct answer is c). Note that a) may also be true, but you want to pick the one that shows you have actually learned something new.

Terri decides to play the lottery. She has 1% probability of winning $1000 and a 99% probability of winning zero. The expected value of her decision to play is

a) $1000

b) $100

c) $10

d) $1

e) 0

The correct answer is $10.

The lemons model is used to explain

a) the market for citrus products

b) markets with asymmetric information

c) just the market for used cars

d) how not to buy a lemon in the first place

e) markets with symmetric information

The correct answer is b.