Econ Lab · Markets

Asymmetric information

Imagine buying coffee beans you cannot taste or inspect first. Some bags are excellent, some are stale, and they all look the same on the shelf. How much would you pay? Not the price of a great bag, since it might be stale. You pay for the average. And that single, sensible move is enough to break the market.

Drag the slider and watch the offered price fall short of what good beans need.

02468100246810
Average quality buyers expect\text{Average quality buyers expect}
Price ($)\text{Price (\$)}
good beans need\text{good beans need}
buyers pay\text{buyers pay}
gap
$6.4\$6.4
6.46.4
$5.1\$5.1

When buyers cannot tell good beans from bad, they will only pay for the average. But at that price the best sellers pull out, which drags the average down, so buyers pay even less. This is adverse selection, and it always pushes the same direction, toward the bottom.

The market is unravelling in plain sight. Buyers expect quality 6.46.4, so they offer about 5.15.1 dollars a bag. Beans of that quality need 6.46.4 to stay in, a shortfall of 1.31.3. Those beans walk away, the average quality drops, and tomorrow buyers offer even less. The arrows point left and down, and there is no rung that holds.

The blue line is what buyers will pay for an unknown bag. The clay line is the price good beans need to stay in. The gap is the problem.

Buyers pay for the average

A buyer who cannot judge quality can only guess at the average bag, then pay a fraction of what that average would be worth if it were certain. Here they pay eight tenths of expected quality.

Pbuyers=0.8×qualityP_{\text{buyers}} = 0.8 \times \text{quality}

Good-bean sellers have their own floor. A grower whose beans are worth a certain amount will only stay in if the price covers that amount.

Psellers=qualityP_{\text{sellers}} = \text{quality}

The offer always falls short

Compare the two lines at any quality you like. The price buyers offer sits below the line good beans need, every time. The blue line is flatter, so it can never catch the clay one above the origin. That gap is not a fluke of the numbers, it is the whole story.

So the market unravels

Start high. Buyers expect good beans and pay a fair-ish price, but it is still below what the best beans need, so those beans leave. Now the average is lower, so buyers pay less, so the next tier of beans leaves too. The slide does not stop until you reach the bottom, where quality is low and the price is low and nothing better is left to lose.

What you just did

You watched a market wreck itself with no villain in it. Buyers were reasonable, sellers were reasonable, and good beans still disappeared. This is why used cars come with warranties, why insurers ask for medical histories, and why a trustworthy seller will work hard to prove quality. Each of those is a way to close the gap you just traced.

All modulesBuilt on the Econ Lab graph engine