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Situation 1 In a situation where we have two markets one with good quality products and the other with bad quality products, if we are in a situation where the buyer knows which is the good product and which is the bad we can say that the demand for good quality products is superior to the bad quality ones.

Situation 2 Now if we go from situation 1 to situation 2 where the buyer does not know which is the good or the bad product we can say that the demand for good quality products decreases since the buyer is willing to pay less because he does not kbow if what he is buying is a good product.

Now what I dont understand is why do we say that the demand for bad quality products will increase when the demand for good quality products decreases?

Is it just because the decrease in demand for the good products is the same quantity as the increase in demand of bad product since the two products are the same type but not quality? Or is there another explanation for this ?

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3 Answers 3

In the second case (information asymmetry) there is only a single market. This may be the market for the product with unknown quality or in case of adverse selection it may be a market for the bad quality product alone. Assuming there is no adverse selection the reservation price of a consumer w.r.t. the unknown good is the expected value of his reservation prices from the full information case. Thus it is a weighted average and will fall between the reservation prices of the good quality product and the bad quality product. Since this is true for all consumers, the demand function adjusts in the way you described.

What happens exactly (number of products sold) depends on the market structure, whether the seller of the goods is a monopoly or there is supply-side competition.

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Seems kind of logical, thanks, I will wait to get more answers before accepting yours. –  Amro elaswar Jun 3 at 21:39

Let's take simple, extreme cases.

Scenario 1: The good quality product and the bad quality product are being sold for exactly the same price. Buyers have absolutely zero information about the quality of either. Both have equivalent marketing and availability, i.e. the same number of each are offered for sale, they are in the same number of stores, stores are equally convenient to customers, etc. Then presumably people would buy about 50% good product and 50% bad product.

Scenario 2: Everything the same as scenario 1, except now buyers now exactly which products are good and which are bad. Again, assuming both are readily available to all customers, then presumably people would buy 100% good product and 0% bad product.

So the "no information" market reduces sales of the good product from 100% to 50%, and increases sales of the bad product from 0% to 50%.

Of course in real life the situation is rarely if ever that clear cut. Some consumers will know which products are good and which are bad, while other consumers will not. Even people with perfect information may disagree about which is better. (I may prefer a car that can haul more luggage while you prefer a car that gets better gas mileage.) I may buy a product that I know is lower quality because I can get it at a store that is nearby while getting the higher quality product would require me to travel a long distance and I don't think it's worth the trouble. Etc.

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Assuming the products are substitutes (to some extent), and are distinguishable: an increase in price of the higher quality good will increase demand for the lower quality good. The reverse is also true. The intuition is that as the price of one good increases, all else equal, people prefer to abandon it in favor of the substitute. You may find yourself switching from traditional pig bacon to so-called turkey bacon as the price of pig bacon increases, for example. This happens even though most people believe turkey bacon is of lower quality than traditional bacon.

Sometimes high and low quality products do not substitute, they may be too different to serve the same purpose. For example, consider parachutes. Some fabric is high quality for parachutes and will be used. The low quality fabric for parachutes may never be used (no burlap parachutes!).

If you cannot distinguish the products from one another, in the short run, the chance to get a good (at random) from the combined high/low quality market has a price somewhere between the price of the original high and low quality goods. The larger the proportion of high quality goods in the market, the closer the price will be to that of the high quality good. Speculatively, when the products cannot be distinguished you might have a "market for lemons" in the long run. That is, eventually, high quality producers would choose to cut costs and produce lower quality products instead. The consumers have no incentive to trust the new mix of products, and eventually the market fails or converges to the low-quality price.

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