Game Theory, Market for Lemons and Management Institutes

“George Akerlof’s Nobel prize is richly deserved. He and his co-laureates led a revolution in our understanding of how markets behave when different participants have different information about the qualities of commodities being traded. He showed that in the absence of adequate mechanisms to assure quality and verify and enforce contract provisions regarding quality, markets may fail to form or may do a poor job of allocating resources.”

-Daniel McFadden, Noble Prize winner in field of economics.

 

I did post graduation course in management from Nagpur University, though it was not at par with MBA course of premier institutes, it was adequate to get job. Course structure was simple, consisting of 5 basic courses in 1st year and 4 elective papers in 2nd year.

Our class consisted of mix of talented and average students. But since this course was not highly rated by industry, companies were not interested in visiting campus and there was nothing great about pay package. While average students did not complain, talented students felt that they were underpaid because of reputation of management course.

management grads

This happened because of what is called as asymmetric information i.e. student knows what he is capable of, but the marker (buyer) has no knowledge about student’s talent or quality of his education.

Economist George Akerlof did lot of research in area of asymmetric information and won Nobel Prize in 2001. He gives example of used car market to explain concept of asymmetric information.

cars

A used car market is mix of cars which are of poor quality (lemons) and cars which are in good condition (plums).  For average buyer it is difficult to know the quality of car he is buying (assuming they are not expert in automobile engineering) so on safer side he will always offer average price (average of bargain and premier price). Result is lemon car owner gets higher than his expectations while plum car owner gets lower than his expectations, so he stops selling his car in used car market, this further brings down the average price, resulting in more and more owners of good quality cars quitting the market, this keeps happening till market is left with only lemon cars.

used cars

Let us take an example, suppose lemon car costs Rs.1, 00,000 and plum car Rs.3, 00,000. Since buyer cannot differentiate due to lack of information, he will play safe by offering  average price i.e. 1,00,000+3,00,000/2 i.e. 2,00,000 lakhs. While lemon car owner ends up getting nice profit of 100%, the plum car owner quits market as he will make loss if sells, while buyer feels cheated and loses faith in market. If plum car owners start quitting market, soon market will be left with lemon cars with no buyers.

This theory has lot of applications in various industries esp. banking and insurance industry.

Solution to overcome this problem is to spread more information (reduce asymmetry) and establish agencies who can rate the quality of products being sold, so that buyer and seller benefit.

student loans

Coming back to example of management course, there is need to have a reliable agency which will rate the management institutes, so that student after spending 2 years studying with liability of student loan does not end up with pathetic job.

 

 

 

 

 

 

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