carnes@gargoyle.UUCP (Richard Carnes) (11/28/85)
In response to the postings concerning the "market for lemons" model, Radford Neal writes: >The postings on this subject seem to me to be singularly unenlightening. This posting is guaranteed to be a source of enlightenment, or your money will be cheerfully refunded. > 1) Limited information is an essential characteristic of the real world. > Saying the free market is flawed because not everyone knows everything > is silly. But it is not silly to point out that, because of unequally distributed information, government intervention can outperform the free market in some situations. I'll try to explain how this happens. First, I will let George Akerlof explain the point (from his article in *Quarterly J Econ* 84(3), 1970): There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller [multi-person Prisoner's Dilemma -- RC]. As a result there tends to be a reduction in the average quality of goods and also in the size of the market. It should also be perceived that in these markets social and private returns differ, and therefore, in some cases, governmental intervention may increase the welfare of all parties. Or private institutions [guarantees, brand-name goods, chains] may arise to take advantage of the potential increases in welfare which can accrue to all parties. By nature, however, these institutions are nonatomistic, and therefore concentrations of power -- with ill consequences of their own -- can develop. In order to explain how this happens, we construct a model, using the automobile market as a convenient illustration. NB: This is not supposed to be a realistic description of how the auto market works. A MODEL shows what will happen *given a particular set of assumptions*. So: Let there be just four kinds of cars: new and used cars, and good cars and lemons. A new car is either good or a lemon, and the same is true of used cars. Individual buyers are assumed to know the probability q that the new car they buy is a good car; the probability it is a lemon is (1 - q). By assumption they don't know if a particular new car is good; they only know the proportion of good cars produced, which of course is q. But after owning a car for a length of time, the owner can assign a new, more accurate probability to the event that his car is a lemon. So the owners of used cars know more about the quality of their cars than potential buyers. We are assuming as a hypothesis that it is impossible for a buyer to tell whether a given car is good or a lemon; therefore good and bad used cars must sell at the same price. Now if a used car had the same valuation as a new car, it would be advantageous for the owner of a probable lemon to trade it at the price of a new car, and buy a new car, at a higher probability q of being good than the car he just sold. So the market price of used cars will be lower than that of new cars, and the owner of a *good* used car will be locked in: not only can he not receive the "true" value of his car (what he could get for it if buyers knew its quality), but he cannot even obtain the expected value of a new car. Thus we have a modified version of Gresham's law. Most cars traded will be lemons, and good cars may not be traded at all. Bad cars drive out the good because they sell at the same price, because a buyer, by hypothesis, has no way of telling the difference between good cars and lemons. So that is the first model. Akerlof goes on to show that worse things can happen when we assume that there are different grades of quality, not just good/bad. In this case it is possible to have the bad driving out the third-rate driving out the second-rate driving out the first-rate, so that eventually no goods will be traded at any price level. Utility theory is used to derive this result. Now how do these models pertain to the real world? One application is to insurance. People over 65 have great difficulty in buying medical insurance. Why doesn't the price rise to match the risk? As the price level rises the people who insure themselves will be those who are increasingly certain they will need the insurance; it is easier for the applicant to assess the risks involved than the insurance company. So the average medical condition of applicants deteriorates as the price level rises, so that insurance sales may not take place at any price; just as the average quality of used cars supplied fell with a corresponding fall in the price level. As an insurance textbook puts it: Generally speaking policies are not available at ages materially greater than 65.... The term premiums are too high for any but the most pessimistic (which is to say the least healthy) insureds to find attractive. [O.D. Dickerson, *Health Insurance*] The principle at work here is called "adverse selection," and is potentially present in all lines of insurance. Akerlof again: This adds one major argument in favor of medicare [since insurance companies must screen their applicants, especially those who seek insurance on their own initiative -- insurance is not a commodity available for sale to all buyers]. On a cost benefit basis medicare may pay off: for it is quite possible that every individual in the market would be willing to pay the expected cost of his medicare and buy insurance, yet no insurance company can afford to sell him a policy -- for at any price it will attract too many "lemons." The welfare economics of medicare, in this view, is *exactly* analogous to the usual classroom argument for public expenditure on roads. The same argument may apply to Social Security, conceived as a form of poverty insurance: the private sector would not provide it, even though both buyers and sellers would be better off with it, by free-market criteria. Another real-world application concerns the employment of minorities. Contrary to conservative dogma, the motive of profit maximization may lead employers to refuse to hire members of minorities for certain jobs, since ethnic group may serve as a good statistic for the applicant's quality of education and general job capabilities. An employer may make a rational decision not to hire any blacks, say, for responsible positions: it may be difficult to distinguish those with good qualifications from those with poor qualifications because many of them were educated in inner-city schools whose certification of students' abilities is deemed unreliable, so that good grades convey only limited information about job applicants' abilities. As George Stigler wrote, "in a regime of ignorance Enrico Fermi would have been a gardener, Von Neumann a checkout clerk at a drugstore." The rewards for good work in slum schools tend to accrue to the group as a whole, raising its average quality, rather than to the individual. So this is an argument for affirmative action that I can only sketch here: at least in some circumstances, it can *increase* the efficiency of the job market, precisely because information is unequally distributed. Some other applications of the lemons model: Dishonesty in business is a serious problem in underdeveloped countries. Our model gives a possible structure to this statement [and permits us to evaluate the costs of dishonesty].... Credit markets in underdeveloped countries often strongly reflect the operation of the Lemons Principle.... [An example] ... concerns the extortionate rates which the local moneylender charges his clients. In India these high rates of interest have been the leading factor in landlessness. [The credit market is similar to the insurance market.] Various institutions can arise to reduce quality uncertainty: guarantees, brand-names, chains (the Howard Johnson's on the interstate provides a better hamburger than the *average* local restaurant), and licensing, degrees, and even the Nobel Prize. Akerlof points out the importance of *trust* in economic transactions. Informal unwritten guarantees are preconditions for production and trade. Business will suffer where these guarantees are indefinite or lacking: the lemons tend to drive out the plums. I'll try to elaborate on these points and respond to comments when I have time, which may be very soon indeed, possibly within six months. -- Richard Carnes, ihnp4!gargoyle!carnes
radford@calgary.UUCP (Radford Neal) (11/30/85)
> In response to the postings concerning the "market for lemons" model, > Radford Neal writes: > > >The postings on this subject seem to me to be singularly unenlightening. > > This posting is guaranteed to be a source of enlightenment, or your > money will be cheerfully refunded. > > > 1) Limited information is an essential characteristic of the real world. > > Saying the free market is flawed because not everyone knows everything > > is silly. > > But it is not silly to point out that, because of unequally > distributed information, government intervention can outperform the > free market in some situations. I'll try to explain how this > happens. As the following quote admits, you don't in fact explain how government intervention is necessary: > First, I will let George Akerlof explain the point (from his article > in *Quarterly J Econ* 84(3), 1970): > > There are many markets in which buyers use some market statistic to > judge the quality of prospective purchases. In this case there is > incentive for sellers to market poor quality merchandise, since the > returns for good quality accrue mainly to the entire group whose > statistic is affected rather than to the individual seller > [multi-person Prisoner's Dilemma -- RC]. As a result there tends to > be a reduction in the average quality of goods and also in the size > of the market. It should also be perceived that in these markets > social and private returns differ, and therefore, in some cases, > governmental intervention may increase the welfare of all parties. NOTE THE FOLLOWING: > Or private institutions [guarantees, brand-name goods, chains] may > arise to take advantage of the potential increases in welfare which > can accrue to all parties. By nature, however, these institutions > are nonatomistic, and therefore concentrations of power -- with ill > consequences of their own -- can develop. So your own authority says that the market can provide these benefits also, but that this would be bad for other reasons. What he means by "nonatomistic" and why he thinks any concentrations of "power" which the market would develop are worse than concentrations in governments is unclear from this quote, so I won't attempt a refutation at this time. > Richard Carnes, ihnp4!gargoyle!carnes Radford Neal
nrh@inmet.UUCP (11/30/85)
>/* Written 8:57 pm Nov 27, 1985 by carnes@gargoyle in inmet:net.politics */ >/* ---------- "Re: The free market" ---------- */ Richard, Thanks for the nice article: >This posting is guaranteed to be a source of enlightenment, or your >money will be cheerfully refunded. You can keep every cent of MY money! I found it most enlightening, but perhaps a little misleading. >> 1) Limited information is an essential characteristic of the real world. >> Saying the free market is flawed because not everyone knows everything >> is silly. > >But it is not silly to point out that, because of unequally >distributed information, government intervention can outperform the >free market in some situations. I'll try to explain how this >happens. >First, I will let George Akerlof explain the point (from his article >in *Quarterly J Econ* 84(3), 1970): >[....] > be a reduction in the average quality of goods and also in the size > of the market. It should also be perceived that in these markets > social and private returns differ, and therefore, in some cases, > governmental intervention may increase the welfare of all parties. > Or private institutions [guarantees, brand-name goods, chains] may > arise to take advantage of the potential increases in welfare which > can accrue to all parties. By nature, however, these institutions > are nonatomistic, and therefore concentrations of power -- with ill > consequences of their own -- can develop. Sauce for the goose -- sauce for the gander. It is *ALSO* true that governments are nonatomistic. The rest of your article depends, it seems to me, on the idea that government's actions would be benevolent and disinterested. In your MODEL it is quite true that government CAN act this way; Real world governments need not act this way, of course, for the notion that a government CAN act this way to be supported by your model. On the other hand, you could have built fairies or elves into the model and given them the same role. You would then be safe from accusations that "Fairies don't REALLY act this way", but the model would not have carried the implication that government could be depended on to help in the real world. Note that I'm NOT saying that you deliberately misinterpreted anything, merely that your model makes the presumption that the government is not, in fact, acting the way governments do (for example, that it's not imposing import quotas, or safety checks that turn out to be statistically unrelated to safety). Given this presumption, yes, a government could aid a market economy in assigning the prices of cars. A similar statement on the part of a rabid free-marketeer would be that folks in a free market CAN overcome free rider situations by simply choosing to be reasonable and pay their share even though nobody can force them to. In both the used-car situation and in the situation where government is asked to make ALL private decisions, there's nothing wrong with saying that a directed economy CAN outperform a free economy; the government (and the population under it) simply has to be very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, very, VERY lucky. You don't DEPEND on monkeys at typewriters to write Shakespeare, neither should you depend on pencil-pushers in Washington to have your interests, your information, and your dislikes as perfectly integrated as you do. And in free-rider situations? If the government could be given ONLY the power to deal with these, and only the power to do it well, then government would indeed be my favorite Uncle. 'Til then....