Ewu Eco 301 Assignment
Ewu Eco 301 Assignment
The Market for Lemons: Quality, Uncertainty and the Market Mechanism is 1970 paper by the economist George Akerlof. It discussed information asymmetry which occurs when a seller knows more about a product than a buyer. Imagine that owners of lemons are willing to sell for $1000 and owners of plums are willing to sell for $2000. Imagine that purchasers are willing to pay up to $1200 for a lemon and up to $2400 for a plum. Assume that sellers know what kind of car they have, but buyers can't tell. All buyers know is that half of all used cars are lemons. Therefore, based on the expected probability that a given car is a lemon, they will pay only up to $1800 for any car (1/2*1200 + 1/2*2400). But plum owners aren't willing to sell for only $1800, so only lemon owners will sell. The logical conclusion is that only the lemons will be sold, and the equilibrium price will be between $1000 and $1200. The mere presence of inferior goods destroys the market for quality goods (an externality problem) when information is imperfect. Plum owners need some way of signaling their car's quality. Possible market solutions: warranties/guarantees (shared risk), iterated interaction (brand names, chains), certification (diplomas, JD Powers, credit reporting). Possible non-market solutions: government certification agencies (FDA), licensing. To put this in terms of X and Y, asymmetric information (X) leads to adverse selection (Y).
Asymmetric information: The buyer and seller have unequal information about the vehicle's type. Adverse selection: The buyer risks buying a car that is not of the type he expects-e.g. buying a lemon when he thinks he is buying a plum.
Basically, the "lemon principle" is that bad cars chase good ones out of the market. This is related to Gresham's law (bad money drives out good money through mechanism of exchange rates).
existing prices constant. This high degree of interdependence and need to be aware of what other firms are doing or might do is to be contrasted with lack of interdependence in other market structures. In a perfectly competitive (PC) market there is zero interdependence because no firm is large enough to affect market price. All firms in a PC market are price takers, as current market selling price can be followed predictably to maximize short-term profits. In a monopoly, there are no competitors to be concerned about. In a monopolistically-competitive market, each firm's effects on market conditions are so negligible as to be safely ignored by competitors. Non-Price Competition: Oligopolies tend to compete on terms other than price. Loyalty schemes, advertisement, and product differentiation are all examples of non-price competition.
Figure: 11.4
marginal revenue, we first determine its total revenue, which can be described as follows Total Revenue = P * Q1 = (100 - Q) * Q1 = (100 - (Q1 + Q2)) * Q1 = 100Q1 - Q1 ^ 2 - Q2 * Q1 The marginal revenue is simply the first derivative of the total revenue with respect to Q 1 (recall that we assume Q 2 is fixed). The marginal revenue for Firm 1 is thus: MR1 = 100 - 2 * Q1 - Q2\ Imposing the profit maximizing condition of MR = MC , we conclude that Firm 1's reaction curve is: 100 - 2 * Q1* - Q2 = 10 => Q1* = 45 - Q2/2 That is, for every choice of Q 2 , Q 1 * is Firm 1's optimal choice of output. We can perform analogous analysis for Firm 2 (which differs only in that its marginal costs are 12 rather than 10) to determine its reaction curve, but we leave the process as a simple exercise for the reader. We find Firm 2's reaction curve to be: Q2* = 44 - Q1/2 The solution to the Cournot model lies at the intersection of the two reaction curves. We solve now for Q 1 * . Note that we substitute Q 2 * for Q 2 because we are looking for a point which lies on Firm 2's reaction curve as well. Q1* = 45 - Q2*/2 = 45 - (44 - Q1*/2)/2 = 45 - 22 + Q1*/4 = 23 + Q1*/4 => Q1* = 92/3 By the same logic, we find: Q2* = 86/3 Note that Q 1 * and Q 2 * differ due to the difference in marginal costs. In a perfectly competitive market, only firms with the lowest marginal cost would survive. In this case, however, Firm 2 still produces a significant quantity of goods, even though its marginal cost is 20% higher than Firm 1's.