The market forces efficiency in that all firms are

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The market forces efficiency, in that all firms are forced to charge the same, low price, and firms are forced to seek out the most efficient methods of production. The market provides consumers what they want at a price consistent with efficient production. With information asymmetries, the efficiency of the market breaks down. When one party has more information than the other, they can use that to their own advantage in the market. The party with less information may be unwilling to trade due to her lack of market knowledge. The party with more knowledge can benefit from market participation. In general, adverse selection occurs when a buyer lacks information to ascertain the quality of the product, so she may then refrain from purchasing that product. The market becomes dominated by low-quality products. Moral hazard occurs when the seller lacks information, so the buyer is able to transfer some of the costs of the transaction to another party, either the seller or someone external to the transaction. The incentives for risk- taking become perverse. Adverse Selection Adverse selection occurs before the transaction, when the buyer lacks information about the quality of the product. Because of this lack of information, buyers are not willing to pay a price high enough to bring high quality products into the market, so the market becomes dominated by low-quality products. This is known as the Lemons Problem, from a famous paper by George Akerlof. The Lemons Problem The Lemons Problem was first introduced in a paper by George Akerlof (1970) for which he won the Nobel Prize. It is one of my favorite models in all of economics. The model goes as follows: Assume that the used car market consists of two types of automobiles, high quality “peaches” and low-quality “lemons”. Information asymmetry exists in that sellers of used cars know the quality of the automobile more than the buyers of used cars. In general, buyers do not know if they are purchasing a peach or a lemon. Since buyers do not know the quality of used cars, they can only assume that a car will be of only average quality. Since they assume that cars are of average quality, they are only willing to pay an average price. The average price that buyers are willing to pay is enough to bring lemons into the market, but not high enough to bring peaches into the market. Without intermediaries, the used car market would be dominated by lemons. Intermediaries in the used car market take the form of used car dealers. They help to reduce the lemons problem by gaining expertise in the purchasing of used cars so they can judge their quality. They also offer warranties to used car buyers so they have more 74
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Econ 350 U.S. Financial Systems, Markets and Institutions Class 8 information about the quality of cars. By acting as intermediaries, used car dealers help to increase the efficiency of the used car market through their provision of information and expertise. Without this type of intermediation, the used car market would likely flounder as individuals would be unable to select high-quality cars.
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