Good Apples or Bad Apples?
When markets have perfect information, better quality producers are able to earn more for their higher quality products. However, when markets lack perfect information, and we can not tell the true quality of the product, markets lead to an inefficient outcome.
The Theory
Akerlof (1970) called this the lemons problem. When true quality of products can vary, the market price will be the price of average quality. This causes higher quality producers to exit the market, and we are left with low quality producers and the price is now based on the average of low quality produce. Now, the upper half of the lower quality producers will leave the market. As this continues, all producers will leave and we will be left with no market at all.
Now lets extend this and say that the market has two types of sellers (Genesove 1993). Let us consider a hypothetical apples market where true quality of apples is unknown to buyers. Buyers only know that there are two types of sellers. The first type (Type 1) only produces apples for sale. The second (Type 2) produces apples for sale and for their own personal consumption. As a buyer, who would you want to purchase apples from?
Economics says you should buy your apples from Type 1. This seller brings all produce to the market, the excellent, good, and bad. Type 2 sellers would retain the excellent apples for themselves and only sell the good and bad apples. Therefore, type 1 producers provide higher quality apples to the market and will receive higher prices.
APPLICATION
Lets apply to this to regulation. Lets assume you have two types of regulators. The first type (Type 1), only regulates the market and all firms being regulated can compete in the market for financing. Therefore, the market for financing in Type 1 environment will include excellent, good, and bad firms. The second type of regulator (Type 2), regulates the market and chooses to invests in some of the firms that it is responsible for overseeing. By choosing to invest in some firms and allowing other firms to go into the market, the regulator is sending a signal to the market that they have chosen to invest in the excellent quality firms and have let good and bad quality firms go find their own financing in the market. The Economic outcome is that this behavior will reduce the prices and investment outlook for all firms that the regulator chose not to invest in, regardless of their true quality.
Regulators will hinder the overall market if they choose to also be investors. A better option is to separate the investment and regulatory authority.
For horse racing fans here is an application by Chezum and Wimmer. Both are graduates from University of Kentucky’s Economics Department and worked with my dissertation advisor Frank Scott.
