Question

ASSUMPTION: Perfect information about the present. Buyers and sellers know everything there is to know about the goods being exchanged. Also, each is aware of the wishes of every other potential buyer and seller in the market.

REALITY: The world is full of lemons-goods about which the buyer is inadequately informed. Also, people are not mind-readers, so sellers get stuck with surpluses and willing buyers are unable to find the products they want.

Questions:

Explain how, if the assumption is violated, there is the possibility of "market failure" or less than optimal economic results. A real-life example here might help with your explanation, provided the example clearly relates to the assumption and the resulting market failure.

Also, explain why you think the assumption is or is not a realistic, reasonable market assumption?

Answer 1

The assumption of perfect information among buyers and sellers is used in almost all economic consumer theory models. The laws of demand and supply also hold if this assumption stands.

Lemon goods are the products in the market which are bought by people due to lack of information and they have a bad performance and low durability. These are the bad purchases consumers make due to their lack of information. Since the consumers, in reality, to do not have sufficient information about the product, sellers can take advantage of this and sell bad quality products or products which do not really fulfil the needs of the buyer- by advertising or portraying them as high-quality products. e.g The Volkswagen Jetta was sold as a clean car for years and years telling the consumers that it was the cleanest Tdi engine until the scam broke out, as to how the company fooled consumers (especially environmentally sensitive consumers) by selling a polluting car by the name of a clean car. Again, this was made possible as the consumers lacked information about the engine testing procedures and Volkswagen took advantage of that.

Asymmetry of information exists, and there is no denying that. When from the buyers' side, consumers end up with either overpriced goods ( lack of information about the price if the product) or lemon goods (lack of information about the quality of the product). When from the sellers' side, it may lead to overstocking or understocking of goods. Demand is merely estimated and cannot be exactly computed ever. The sellers cannot be sure how their product will perform in the market.

These asymmetries lead to market failures. e.g. If a seller is unsure of the demand and he produces less than the actual demand, with higher demand and lower supply, the prices of that product will shoot up. If the seller is unable to increase production in the short run, then the supply may not increase. This will lead to less than optimal economic results. Also, the seller may lose the value of its brand and the product due to the unavailability of the product. If market substitutes are made available, people will shift to the other substitute product at a lower price.

These assumptions hence, cannot be realistic, as asymmetries of information are widely prevalent and often can lead to market failures.