[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Actions such as providing a better guarantee or a larger showroom are taken
not just for the direct benefit that the consumer receives from them, but because
they persuade consumers that the product is a better product or the firm is a better
business to deal with. In a sense, the desire to convey information “distorts” decisions,
insofar as they no longer conform to what they would have been in a world of perfect
information. For example, if customers receive no direct benefit from a luxurious
showroom, the cost of building and maintaining it is a waste of resources.
JUDGING QUALITY BY PRICE
There is still another clue that buyers use to judge the quality of what they are about
to purchase: price. Consumers base inferences about the quality of goods on the
price charged. For example, they know that on average, if the price of a used car is
low, their chance of getting a lemon is higher. Many if not most sellers know that
buyers know this.
In markets with imperfect information, firms set their prices. And in setting
their prices, they take into account what customers will think about the quality of the
good being sold. Concerns about the (correct or incorrect) inferences that consumers
may make about quality impede the effectiveness of price competition. In
the used-car example, we saw that as price rose, the average quality of cars on the
market increased. But if firms think customers believe that cars being sold at a
lower price are lower quality, then they will not lower the price—to do so would
scare away customers who perceive that such “bargains” must be lemons. Under
such circumstances, even if firms cannot sell all they would like at the going price,
they still will not cut prices.
Information problems fascinate economists because they turn the basic competitive
model upside down. Economists have long recognized that prices convey
critical information about scarcity in a market economy. But only recently have the
other informational roles of prices—and their consequences—become clear. When
they can, sellers will manipulate prices to control the information conveyed. Buyers,
for their part, usually see through these manipulations. And their suspicion that the
seller is trying to pass off a lemon discourages trade. When these sorts of information
problems are severe, markets are thin or even nonexistent. Moreover, price
competition may be limited. Even when there is an excess supply of goods, firms
may not cut their prices and the market may not clear.
Wrap-Up
SOLUTIONS TO ADVERSE SELECTION
PROBLEMS IN MARKET ECONOMIES
Signaling
Judging quality by price
336 ∂ CHAPTER 15 IMPERFECT INFORMATION IN THE PRODUCT MARKET