BEEM117 Economics of Corporate Finance

1. BEEM117Economics of Corporate Finance Lecture 2

2. Asymmetric Information • What happens to market outcomes when there is asymmetry of information between sellers and buyers (or investors and borrowers)? • If an entrepreneur wants financing of a project, (s)he knows the intrinsic worth of the project. • George Akerlof first posed this problem in 1970, in what became a Nobel prize-winning paper.

3. The market for lemons • He used the analogy of the used car market. • In the US, a bad quality used car is called a ‘lemon’, hence the name for the model. • Assume an economy where one can purchase a new or used car. Cars can either be good quality cars or lemons.

4. The market for lemons • Let: • Ng be the value of a new good car; • Nl be the value of a new lemon; • Ug be the value of a good used car; • Ul be the value of a lemon. • Let’s make three assumptions (for simplicity): • The value of a lemon is zero (i.e. Nl = Ul = 0); • Half of all cars are lemons (so half are good cars); • New good cars are worth more than good used cars: (Ng > Ug > 0).

5. The market for lemons • So the expected value of a new car is: • EN = 0.5*Ng + 0.5 Nl = 0.5*Ng • Also, the expected value of a used car is: • EU = 0.5*Ug + 0.5 Ul = 0.5*Ug • So, a new car is worth on average more than a used car: • EN > EU

6. The market for lemons • There are four types of agents in the economy: • New car dealers who only sell new cars; • First time car buyers; • Owners of good used cars; • Owners of used lemons. • Importantly, the quality of a new car is unknown even to the seller; hence the price of a new car is Pn. • However, the quality of a used car is known to the seller but not the buyer. • Still a buyer cannot distinguish a good used car from a used lemon. Hence the price of a used car is Pu.

7. The market for lemons • A first time buyer’s utility is equal to: • EN – Pn if (s)he buys a new car; • EU – Pu if (s)he buys a used car. • The owner of a used car has the choice of selling his car to buy a new one or keeping it: • EN – Pn + Pu in the former case; • Ug in the latter. • Finally the seller of a lemon also has the choice of selling his car to buy a new one or keeping it: • EN – Pn + Pu in the former case; • Ul in the latter.

8. The problem of the first-time buyers • Since first-time buyers do not own a car, they will buy whichever type gives them the highest level of utility. • Hence they will buy a used car if: • EU – Pu ≥ EN – Pn. • Solving this inequality for Pu, we get: • Pu ≤ EU – EN + Pn, or premium • Pu ≤ Pn – (Ng – Ug)/2

9. The problem of the lemon seller • The lemon seller can either keep his car and get 0 utility, or selling it to buy a new one. • He will sell his car, as long as: • 0 ≤ EN – Pn + Pu • Solving for Pu: • Pu ≥ Pn – EN, or • Pu ≥ Pn – 0.5 Ng

10. The problem of the good used-car seller • The good used-car seller can either keep his car and get Ug utility, or selling it to buy a new one. • He will sell his car, as long as: • Ug ≤ EN – Pn + Pu • Solving for Pu: • Pu ≥ Pn + Ug – EN, or • Pu ≥ Pn + Ug – 0.5Ng

11. The market for lemons • The upshot of the model is that the prices at which good used car owners are willing to sell and the prices at which first time buyers are willing to buy used cars don’t coincide. • Therefore, lemons drive out good used cars! • Is this realistic? Are lemons so widespread? • Bond (1982) and Offer (2007) test this model in the used pick-up truck and car markets. They find little evidence of the lemon hypothesis.