Experimental Market for Lemons Surpluses of the Participants under Various Conditions

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1 Experimental Market for Lemons Surpluses of the Participants under Various Conditions MARTIN POLÍVKA Department of Economics and Quantitative Methods University of West Bohemia Husova 11, , Pilsen CZECH REPUBLIC Abstract: Markets where the sellers are better informed about the quality of the traded goods than the buyers are in the real world not rare, especially in retail sector. This information asymmetry can result into the harming of the buyer, who deliberately purchases product of bad quality for the price of good one. Various arrangements have been invented so as to balance such asymmetry and to improve the position of the buyers so far. Aim of our research was to investigate the effectiveness of three of such arrangements using the approach of experimental economics. Series of experimental auctions with information asymmetry about quality with three variable treatments representing the discussed arrangements was realized. Obtained results suggest that from the tested arrangements only the higher probability of quality controls is able to significantly improve the situation of the buyers. Key-Words: buyers surpluses, experimental Dutch auction, market for lemons, quality controls, 1 Introduction The markets with the information asymmetry, where the sellers exactly know the quality of their products while the buyers not, appears in the real world quite frequently. Especially in retail, where on the one side stands some specialized company, while on the other side final consumer who purchases dozens of various goods every day (and is therefore not able to collect exhaustive information about each of them) is the information superiority of the sellers indisputable. George Akerlof in his seminal article [1] created a microeconomic model of such situation and claimed that it could lead even to the complete perishing of such asymmetric market. Although this conclusion is rather questionable (after all, the market of the used cars which the Akerlof mentioned as an example still exists) this asymmetry can undoubtedly lead to the negative outcomes for the worse informed participants of the market, who faces the risk of buying poor-quality goods ( lemons in the Akerlof s terminology) for the price they attribute to the high quality products ( cherries ). Surplus which the buyer gets from the exchange can then be significantly lower or even negative. Both the public authorities and private initiatives come up with various arrangements, which are intended to balance this asymmetry and prevent sellers from misusing their information superiority. Situation when the buyers purchase some substandard product still appears, though, and the discussion about the effectiveness of the existing arrangements and possible creation of some new ones still continues. In our research we intended to study the efficiency of such arrangements using the approach of experimental economics. Economic experiment with variable treatments representing some of the possible arrangements was created and realized and obtained results were analyzed so as to investigate, whether these arrangements have any effect on the surpluses of the buyers. 2 Problem Formulation Probably the oldest experimental design representing the market for lemons model is the one presented by Miller and Plott [2]. Other examples of this type of experiments can be found in the work of Holt and Sherman [3], Cason and Gangadharan [4], Wolf and Myerscough [5] or Wilson and Zillante [6]. Design used in our research, which will be presented in the subchapter 2.1, is inspired mostly by the educational experiment of Holt and Sherman [7], which we extended and modified in several ways. Apart of the rather technical changes, such as the different number of participants or rounds, there are two main modifications. Firstly, three variable treatments which represented three possible ISBN:

2 arrangements intended to discourage sellers from offering substandard goods were added and secondly the posted-offer auction mechanism was replaced by the Dutch one. These main modifications will be interpreted and discussed in subchapter Experimental design There are 10 participants in every session, which are randomly divided into 5 sellers (identified by letters A E) and 5 buyers (α ε). Sellers and buyers are seated in the opposite sides of the class and record sheets are handed to them. They are forbidden to communicate with each other during the whole experiment. Experiment is played in rounds, every session contains 6 rounds. Each seller offers one product per round. Firstly, he chooses its quality he can either offer product of regular quality (i.e. cherry ) or a substandard one (i.e. lemon ). The first option means for him costs c, in case of the other option the costs are only l*c, where the values of c ϵ {25, 30, 35, 40, 45} and they are rotated through the five sellers and five rounds of experiment while in the last round all sellers have c = 35. The reduction coefficient l is the first variable treatment of the experiment. It has two levels, 0,6 and 0,8. Secondly, he sets two border prices. The starting price (i.e. the highest one, for which the auctioneer starts to bid the product of this seller) and the last acceptable one (i.e. the lowest price for which the auctioneer is allowed to bid). Aim of every seller in experiment is to maximize his surplus, i. e. the difference between the contract price for which his product is sold and the costs. Every seller writes these three decisions (the quality level, starting price and last acceptable price) down into his record sheets and the experimenter collects them. In this moment, the quality level of some product can be controlled. Product of i th seller will be controlled in j th round with the probability p ij. The probability of quality control is the second variable treatment of the experiment, also with two levels 0,05 and 0,25. So as to determine which (if any) products will be subjected to the control, the experimenter generates five random integers from 1 to 100. Product of the i th seller is controlled when its integer equals or is lower than the set probability level. The control means that the experimenter looks into the record sheets of the seller in question and finds out the quality level of the product. In case it is regular one, this information is told to all consumers. If it is of substandard quality, the result is also imparted to all buyers and what is more this product is excluded from the auction, which means that its seller will not gain any surplus in that round. After the controls, the products which either passed the test or were not tested at all proceed to the auction. The auctioneer verbally bids all products which are available at the current price. If some product reaches the last acceptable price for its seller, it is pointed out by the auctioneer, so that the buyers know that they have the last chance to purchase from this seller. For example the auctioneer claims: A, B and E offer their products for 37, as for E it is the last bid... etc. Every buyer can purchase one product per round. He is given some reservation price r and his aim in the experiment is to maximize his surplus, calculated as the difference between his r and the contract price he purchases for. Values of r ϵ {30, 35, 40, 45, 50} and they are rotated through the five buyers and five rounds of experiment while in the last round all sellers have r = 40. But the buyer gains the surplus only if the purchased product is of regular quality, while if it is the substandard one, no surplus is gained. Nevertheless, such design could led to the unnaturally risky behaviour, because the rational buyers would prefer purchasing even the most suspicious products (e. g. offered for the suspiciously low price etc.) to buying nothing at all. The reason is that if he bought such dubious product, there is high probability that it would be lemon and he would gain nothing, but there is also some (no matter how low) probability that it would be cherry and he would gain big surplus. On the other hand, if he did not buy anything, his surplus would be certain zero. So as to eliminate this problem, we added one more rule. If some buyer does not purchase anything, he will get one quarter of the lowest surplus gained in this round by other buyers. Buyers purchase products during the auction by raising their hands and identifying the seller they are buying from for example I am buying from seller A for the price 36. When the purchase is confirmed by the experimenter, the buyer writes it (i.e. the contract price and the letter identifying the seller) down in his record sheet. The auction finishes when no product remains on the market i. e. every product was either sold or ended out of the market, because nobody bought it for the last acceptable price set by its seller. After the end of the auction, experimenter collects record sheets of the buyers as well, calculates result of every participant, writes them down into their record sheets and hand them out back to the participants. In other words in this ISBN:

3 moment every buyer finds out, which kind of product he has purchased. In one half of the experiments, this information is private. In the other half this fact is public the experimenter for example claims: buyer α has purchased quality product from seller C, buyer β substandard product from seller A etc. This whether the post-auction information is private or public - is the last variable treatment. 2.2 Interpretation of the experiment In the Dutch auction, every seller sets the starting price, which is entirely up to him and which he hopes to sell his product for. But, if it turns out that no buyer is prepared to purchase his product for that price, the price can be lowered until it does not drop to a level of costs. In other words it is the buyer who has the final say about the price - if he does not consider price of some seller as acceptable, he can purchase from the other one. If there is no seller with the attractive enough bid on the market, the auction proceeds and the sellers must reduce their prices. In our opinion this mechanism is better approximation of the retail market than the postedoffer auction, where only one fixed price is set by the seller and the product is either sold for this price or is not sold at all. Variable treatments appearing in the experiment represent three possible arrangements which can be implemented by the public authorities or private initiatives in order to prevent sellers from offering goods of substandard quality. These arrangements are: a) Some obligatory standards are usually set by public authorities or professional organizations. Their fulfilment is then controlled and their violation penalised. Intensity of such quality controls is represented by the variable treatment p ij in our experiment. b) There are some countries where not only the standards discussed in point a), but even the norms concerning the work safety, environmental protection, etc. are missing or at least not really enforced. Goods manufactured in such countries are therefore usually less expensive, because its producers have a free hand in cost cutting. So that the retailers will not be tempted to import these products of questionable quality at a bargain and offer them to the domestic consumers, the public authorities can either directly ban import from such countries or at least make it difficult by imposing some taxes on it or setting some complicated procedures the imported goods have to go through. Such procedures will then mean additional costs for the importers and reduce the advantageousness of such practices. This possible arrangement is represented by the variable treatment l its lower level stands for the situation, when the sellers are able to import the extremely cheap products of substandard quality, while the higher l represents the situation when such import is either banned or burdened by some of the discussed procedures and the sellers are therefore not able to get the substandard goods for such a bargain. c) If some consumer purchases a product and finds out that it is of substandard quality, he can keep this information to himself. On the other hand, some initiatives have appeared lately, which collect such findings from the consumers and publish them on their web pages, so as to warn other consumers and pillory the seller in charge. This possible arrangement the public pillorying of the sellers of substandard goods is represented by the variable treatment public post-auction information conditions, while the situation when only the consumer knows that he has bought lemon is modelled by private postauction information conditions. 3 Problem Solution 3.1 Data description In order to find out, whether any of the discussed arrangements is really able to raise the consumers surpluses, the described experiment was played repeatedly with the various levels of the variable treatments and sensitivity of buyers surpluses to the particular treatments was investigated based on the obtained results. Three variable treatments, each of them with two levels mean eight different combinations (supposing the factorial experimental design is used). So as to obtain sufficient amount of data for the analysis, every combination was realized four times, which means that 320 subjects (students of the University of West Bohemia participated on the research, bonus points to the Microeconomics exam were provided to them according to their performance as an incentive) took part on the experiment and that every role (i.e. buyer/seller) at every combination of variable treatments was played by 20 subjects. Only the results obtained from the five rounds were taken into account, the last round was omitted so that the effect of the end was avoided. In other words, 100 (20 buyers times 5 rounds) values of the surplus of a ISBN:

4 buyer in a round were obtained for every particular combination of variable treatments. Expected values of these surpluses in the experiments with the different levels of particular variable treatments were compared using the ANOVA tests. Alpha = 5% was chosen as the significance level. MATLAB software was used for the computations. 3.2 Results Following results were obtained: a) EX of the buyers surpluses was 2,517 if the p ij = 0,05 and 3,242 in case p ij = 0,25. P-value = 0,027. b) EX of the buyers surpluses was 2,932 if the l = 0,6 and 2,827 in case l = 0,8. P-value = 0,749. c) EX of the buyers surpluses was 3,105 if the post-auction information conditions were private and 2,655 in case they were public. P- value = 0,170. To sum up these results, only the higher probability of quality controls was able to significantly raise the average surplus which buyer gains from the exchange. On the other hand, neither the public information conditions nor the lower reduction of the costs of the substandard product in comparison with the regular one showed any significant positive effect for the buyers. Quite surprisingly, the EXs of the buyers surpluses were even higher in the experiments where the l = 0,6 and where the information conditions were private, even though these levels of variable treatments should logically lead to the more frequent offering of lemons (because under such condition the environment is more convenient for the lemon-sellers ), i.e. to the higher probability of purchasing lemon and gaining zero surplus from the point of view of the buyers. Nevertheless, as stated above, these differences are statistically insignificant and would have to be confirmed at first by some other, more extensive research, before they could be taken seriously. 3.3 Discussion In the previous subchapter was shown that higher probability of quality controls is able to improve the position of the buyers on the market and raise their surpluses gained from purchasing of products. Nevertheless, if such finding should serve as the supportive information for policy making, it would be useful to know the impact of the more frequent controls on the sellers as well. If such arrangement had had a potency to significantly improve the situation of buyers, but would have also mean general worsening for the sellers, its implementation would be probably much more controversial and problematic. So as to investigate effect of the quality controls on the sellers, similar approach as in case of the buyers was used. Expected values of the surpluses of sellers from the 5 rounds in the experiments where p ij = 0,05 and p ij = 0,25 were calculated and compared using the ANOVA test. It turned out that the EX of the sellers surpluses was 5,554 if the p ij = 0,05 and 5,279 in case p ij = 0,25, P-value = 0,511. In other words the higher probability of quality controls did not lead to any significant decrease of the sellers surpluses, which means that the raising of the frequencies of quality controls may be a generally acceptable arrangement, which will help the buyers and will not harm the sellers. This result might seem surprising, though. How it is possible to improve the situation of buyers and not to worsen the situation of sellers at the same time? The answer was found using one ANOVA test more, this time in order to compare the EXs of the contract prices in the experiments where p ij = 0,05 and p ij = 0,25. The EX of the contract prices was 36,592 if the p ij = 0,05 and 37,514 in case p ij = 0,25, P-value = 0,013, i.e. the contract price significantly rose with the higher probability of quality controls. The change of the situation when the p ij rises is therefore following. With the more quality controls, less lemons enter the market and are successfully sold, which ultimately means less zero surpluses among the buyers and also the rise of the average surplus of a buyer per round. This fact simultaneously decreases the opportunity for the sellers to successfully sell lemons for the prices of cherries and gain extraordinary surpluses, which should also lead to the decrease of the average surplus of a seller per round. Nevertheless, the drop of the amount of the lemons offered on the market means rise of the average quality of traded products. And, fully in compliance with the Akerlof s [1] model, this increase is followed by the increase of the contract prices which are the buyers prepared to pay. Higher average contract price then ceteris paribus raises also the average surplus of a seller per round. As obvious from the obtained results, the positive effect of the price rise on the sellers surpluses balances the negative effect of the lower chance to successfully sell a lemon, which is the reason that the sellers surpluses remained intact even when the probability of quality controls rose. ISBN:

5 4 Conclusion As in every experimental study (and especially in case of institutional engineering), the obtained results must be interpreted cautiously and should not be used for formulating of categorical conclusions without further judicious analysis. What is more, the realized research was only a pilot study. Before the obtained results could serve as valid information for the microeconomic policy, following conditions had to be fulfilled at least: a) Discussed experiment had to be repeated and replicated (for the difference between these two terms see [8]), using the other groups of participants, incentives, different settings of the variable treatments etc. so as to test the robustness of the results against the changes of the conditions. It would be also good not to limit these replications on the classrooms (where the number of participants is necessarily restricted) only, but try to realize this experiment as the large scale experiment via electronic media as well. b) Other important factors, such as the implementation costs of the particular arrangements etc. would have to be reflected in the experimental design. Nevertheless, with regard to these reservations, results of the realized experimental study can be concluded and interpreted in following way. If there is social demand for some arrangement, which would be able to improve the situation of the consumers on the markets with the asymmetrical information about quality of traded goods, increasing the frequency of quality controls seems to be appropriate arrangement, which is able to help the consumers. What is more, this arrangement harms only those sellers who offer lemons, but not all sellers in general. On the other hand, the other two potential arrangements imposing of some taxes or bureaucratic procedures on the imports with questionable quality and public pillorying of the sellers who offered substandard goods seem not to be tools that could be able to accomplish such a task. [2] Miller, R.M., Plott, Ch.R., Product Quality Signalling in Experimental Markets, Econometrica, Vol. 53, No. 4, 1985, pp [3] Holt, Ch., Sherman, R., Advertising and Product Quality in Posted-Offer Experiments, Economic Inquiry, Vol.28, No.1, 1990, pp [4] Cason, T.N., Gangadharan, L., Environmental Labeling and Incomplete Consumer Information in Laboratory Markets, Journal of Environmental Economics and Management, Vol.43, No.1, 2002, pp [5] Wolf, J.R., Myerscough, M.A., Reputations in Markets with Asymmetric Information: A Classroom Game, Journal of Economic Education, Vol.38, No.4, 2007, pp [6] Wilson, B.J., Zillante, A., More Information, More Ripoffs: Experiments with Public and Private Information in Markets with Asymmetric Information, Rev. Ind. Organ., Vol.36, No.1, 2010, pp [7] Holt, Ch., Sherman, R., Classroom Games: A Market for Lemons, Journal of Economic Perspectives, Vol.13, No.1, 1999, pp [8] Guala, F., The Methodology of Experimental Economics, Cambridge University Press References: [1] Akerlof, G., The Market for Lemons : Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics, Vol.84, No.3, 1970, pp ISBN: