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Market Failure or Success

The New Debate

Edited by Tyler Cowen and Eric Crampton

Recent years have seen the development of new theories of market failure based on asymmetric information and network effects. According to the new paradigm, we can expect substantial failure in the markets for labor, credit, insurance, software, new technologies and even used cars, to give but a few examples. This volume brings together the key papers on the subject, including classic papers by Joseph Stiglitz, George Akerlof and Paul David. The book provides powerful theoretical and empirical rebuttals challenging the assumptions of these new models and questioning the usual policy conclusions. It goes on to demonstrate how an examination of real markets and careful experimental studies are unable to verify the new theories. New frontiers for research are also suggested.
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Chapter 13: A direct test of the 'lemons' model: the market for used pickup trucks

Eric W. Bond


13. A direct test of the ÔlemonsÕ model: the market for used pickup trucks Eric W. Bond1 This chapter provides an empirical test of one of the implications of models of markets with asymmetric information. In the seminal paper on markets with asymmetric information, George Akerlof (1970) pointed out two possible outcomes that may occur where sellers have better information about the quality of products than do buyers. One possibility is that bad products will drive out good products. If buyers cannot distinguish quality until after the purchase has been made, there will be no incentive for sellers to provide good quality products, and the average quality in the market will decline. In the case of cars, an often-cited example of this phenomenon, owners who discover that they have a ÔlemonÕ will attempt to sell it in the used car market to an unsuspecting buyer. The owner of the ÔcreampuffÕ will not sell his car, since it is indistinguishable from a lemon to buyers and must therefore sell for the price of a car of average quality. The effect of quality uncertainty is to reduce the volume of transactions in the used car market below the socially optimal level. A second possibility 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 some assurance of quality. These institutions may prevent good products from being driven from the market, but they will not necessarily eliminate...

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