Product Quality, Informational Efficiency, and Regulations in Experimental Markets

Abstract

This study reports on the behavior of experimental markets in which product quality is endogenously determined and cannot be observed by buyers prior to purchase. Several theories suggest that with asymmetric information about product quality between buyers and sellers and the absence of properly defined rules of liability, markets cannot be expected to generate products of "optimal grade." According to such theories markets will be informationally inefficient. Information that exists will not be properly used because the wrong people have it. As a result, products that can be cheaply produced but are of undesirable quality ("lemons") will drive good grade products from the market because buyers will be improperly informed at the time of purchase. However, very little noncontroversial evidence exists regarding the proposition. Several modes of behavior and institutions can theoretically intervene to mitigate the problems. In addition, theories are hard to test because measurements of preferences, cost, knowledge, and so forth, of sufficient precision to determine whether a market has "failed" are difficult in naturally occurring environments. The markets we created and studied have fewer such complications.

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