Sunday, October 16, 2005

Quality, Uncertainty and Market Mechanism - Part 1

     A seminal paper by this title published by George A. Akerlof in 1970 was so influential in helping analysts analyze quality and uncertainty in markets under conditions of asymmetrical information flow that in 2001, George A. Akerlof was awarded the Nobel Prize in economics. His paper has been singular in analyzing markets ranging from the used car market to health insurance markets. After being awarded the Nobel Prize, Akerlof penned an interpretive essay on this paper and it can be found [here].

     I have since read his 1970 paper and would like to share the wonderful and thought provoking points he makes by reviewing his paper. In the next section, I will try to give the interested reader a brief run through of the philosophy of Akerlof’s theory. Most of the subsequent sections will be taken right out of his paper simplified, expanded and presented. Of course, he does assume (and so will I) that his readers have been blessed with some exposure to basic economic verbiage. I will provide the necessary information and references to background wherever necessary. I must bring to your notice that most of the language will be his but I will provide explanations/analogies to make things (seemingly) simpler.

A Brief Run Through:
     In the seminal paper on markets with asymmetric information, George Akerlof strives to provide “a structure for determining the economic costs of dishonesty”. He points out two possible outcomes that may occur where sellers have better information about the quality of products than do buyers. There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In these cases, there is incentive for sellers to market poor quality merchandise - if buyers cannot distinguish the quality until after the purchase is made, there is no incentive for the sellers to provide good quality products and the average quality of traded goods will decline below the socially optimal level. This is often referred to as “bad driving out the good”. The explanation for this course of events is fairly logical – if all sellers, despite having the information advantage, traded only in high quality goods then average quality of goods in the market will go up, prizes will stabilize leaving a small operating and profit margin. If under these conditions, a seller makes use of his informational advantage to sell a poor quality product – his profits are much higher and the buyer in his position has no way of determining the quality until after the sale has been made. In Akerlof’s own language – “…. the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller.” Akerlof cited the used car market as an example for his findings – in the case of used cars, buyers who find out much to their chagrin that they are now the proud new owners of a “lemon” will now attempt to sell it to an unsuspecting buyer (such as themselves) in the used car market. As this continues, more lemons make their way to the market and not only does the quality decline but the market itself is threatened as all buyers are wary and there exists a huge disparity between the number of sellers and buyers. Contributing to the declining quality of this market are owners of “creampuff”(s) who do not sell their cars as they are indistinguishable from lemons and the price is dictated by the demand for cars which the buyers suspect to be primarily lemons. Thus, this information asymmetry leads to quality uncertainty which in turn leads to reduced volume of transactions thereby threatening the very survival of the market itself.
     A second possibility as suggested by Akerlof is that institutions may develop to counteract the effects of quality uncertainty. Warranties and brand names can be used to give the buyer an assurance of quality. These institutions may prevent good products from being driven out of the market but will not necessarily eliminate the inefficiency. These institutions may be costly to set up, run and sellers may over invest in signaling the quality of their product to buyers.
     Stabilization (not necessarily efficient) of the market can be attributed to the development of counteracting institutions. The provision of warranties and the seller’s concern for his reputation may prevent sellers from supplying inferior quality products. Another possibility is that the buyer has somehow stabilized the initial information asymmetry by obtaining additional information enabling him to use a more global market statistic to evaluate the quality of the product prior to sale. The market is still deemed inefficient if this stabilization is achieved through costly counteracting institutions or through expensive information search by buyers. In the context of the used car market, this explains the existence of “information stabilizers” such as Kelly’s Blue Book, Car Fax etc.

     I hope everyone appreciates the theory so far. If you have ever bought a used car, you can analyze for yourselves why you did what you did – paid to go through car fax reports, paid mechanics to give a prospective car a once over to ease your fears – all in your attempt to equalize the information flow in the market.

I will post more technical details in upcoming posts.

1 comment:

Z said...

Well I do not agree with the so called "information stabilizers", acccording to me they are BS. They still support the seller from selling inferior products. Sigh!
I will wait for the next part !