Journal of Business Research 60 (2007) 858–867 The impact of quality uncertainty without asymmetric information on market efficiency ⁎ Segismundo S. Izquierdo a, , Luis R. Izquierdo b a University of Valladolid, Spain b University of Burgos, Spain Received 1 March 2006; received in revised form 1 December 2006; accepted 1 February 2007 Abstract The market effects of quality variability and uncertainty have classically been studied in the particular context of asymmetric information, focusing on the sellers' expected behavior and the phenomenon of adverse selection. Looking instead at the consumers' expected behavior, this paper uses an agent-based model to illustrate how quality uncertainty by itself can lead to market failure, even in the absence of asymmetric information. Assuming that buyers estimate the quality of the product they buy on the basis of their experience from previous purchases, and considering quality estimation rules which are individually sensible and unbiased, this paper shows that market interaction with quality uncertainty generally produces underestimation of product quality as well as systematic drops in prices and losses of market efficiency. This study also shows that the spread of information through social networks can greatly mitigate this market failure. © 2007 Elsevier Inc. All rights reserved. Keywords: Quality uncertainty; Quality variability; Asymmetric information; Social networks 1. Introduction The works of Akerlof, Spence and Stiglitz received the Nobel Memorial Prize in Economic Sciences in 2001, and asymmetric Since George Akerlof's seminal paper “The Market for information is now considered to be a key issue in many real Lemons: Quality Uncertainty and the Market Mechanism” markets, being one of the main paradigms underlying what is (Akerlof, 1970), the literature on the issue of asymmetric nowadays known as the economics of information (Macho- information and quality uncertainty has increased considerably. Stadler and Pérez-Castrillo, 2001; Stigler, 1961; Stiglitz, 2000). Following Akerlof's work, economists such as Michael Spence The theory of asymmetric information has proven to be a (Spence, 1973) and Joseph Stiglitz (Stiglitz, 2000) further very fruitful framework for the analysis of many types of developed the implications and applications of asymmetric market, but this approach does not provide a general answer to information. They provided models that could successfully the original question: what is the effect of quality uncertainty in explain many otherwise surprising economic and social a market? The reason for this loss of generality is that, besides phenomena, such as the marked loss of market value suffered quality uncertainty, asymmetric information theory requires by brand-new cars on their first days of use, or the difficulties of some other key assumptions that do not always necessarily young motorcyclists to get insurance cover, even at very high hold, namely: premium prices. – There are reliable quality indicators which, before the commercial transaction takes place, are visible to only one of the potential trading partners, but not to the other (i.e. ⁎ Corresponding author. University of Valladolid, ETS Ingenieros Indus- asymmetric information). For the sake of clarity, and without triales, Po del cauce, s/n, 47011 Valladolid, Spain. loss of generality, let us assume that the sellers are the E-mail address: [email protected] (S.S. Izquierdo). possessors of privileged information. 0148-2963/$ - see front matter © 2007 Elsevier Inc. All rights reserved. doi:10.1016/j.jbusres.2007.02.010 S.S. Izquierdo, L.R. Izquierdo / Journal of Business Research 60 (2007) 858–867 859 – If sold at the same price, producing and selling low-quality to Akerlof's case, however, this study does not assume that items is more profitable than producing and selling high- information is necessarily asymmetric. quality items. To illustrate this argument, this paper will analyze a model – Informed sellers present low-quality items as high-quality that isolates the effects of quality uncertainty from those of ones, and buyers have little or no information about the asymmetric information and adverse selection. Thus, to avoid sellers' trustworthiness. confusing these different effects, the model considers that items – The quality expected by every potential buyer is the market's are homogeneous at the time of sale. By assuming product average real quality of the product (i.e., perfect average homogeneity, adverse selection is necessarily avoided, since information). there is no a priori distinction between high-quality and low- quality items. With these assumptions, given that uninformed buyers Note that product homogeneity does not mean that every cannot discriminate quality before purchasing an item, one item will end up providing exactly the same quality; simply that would expect high-quality and low-quality items to be sold at the quality distribution of every item is the same. For instance, if the same price, which would be a function of the average a product is homogeneous and an item's quality is measured by expected quality. Since the sales of low-quality items are more its service life, all items should have the same life expectancy. profitable at any given common price, the expectation is that Although the literature frequently ignores this point, note that low-quality items will progressively flood the market. This many quality features of any specific item (e.g. the item's process would lower the average quality of the items in the service life) are random variables, since their actual value is market and, consequently, buyers' quality expectations and the only known when the item has been consumed. As noted by market price. Moorthy and Hawkins (2005), products are typically consumed Generally, this situation where sellers (i.e. the informed under noisy conditions, leading to variability in consumers' party) preferably offer items that are less favorable to buyers experiences. Thus, quality homogeneity at the time of (i.e. the uninformed party) is known as adverse selection: it is purchasing should be defined in terms of quality distribution. as if the market selected adverse items for the uninformed In a practical case, product homogeneity is a valid assumption party. For instance, a lung-illness insurance policy offered to if, for instance, every item is manufactured following the same the whole population will (unintentionally) end up selecting standard production process. those individuals who are more likely to suffer from lung Related papers in the literature are those by Bergemann and problems. Valimaki (1996), Ellison and Fudenberg (1995), and Small- With adverse selection, Akerlof showed that it may even be wood and Conlisk (1979), who studied equilibriums in models the case that there is no possible market equilibrium at any with quality heterogeneity (brands with different quality), price. Assume, for instance (Hendel and Lizzeri, 1999), that uncertainty and learning. Johnson and Myatt (2003) studied a the quality q of used cars is uniformly distributed in [0, 1] and Cournot model of competition in which each brand can offer the valuation of a car of quality q is q monetary units for a multiple quality-differentiated products (quality heterogeneity, potential seller and 3q / 2 monetary units for a potential buyer; without uncertainty). Importantly, all these models focus on then, if the quality expected by buyers is the average quality in the effects of differences in the average quality level. In the market, there is no possible market equilibrium for any contrast, this paper isolates the effects of quality variability by number of traded units but zero. To understand this, consider assuming a constant average quality level, but different any equilibrium price p; the average quality of the cars offered degrees of variability. is then p / 2, since only those sellers with cars of a quality Finally, the quality expected by every potential buyer is not below p would be willing to sell their car. In these cir- assumed to be the market's average real quality, since such an cumstances, the buyers' valuation of a car (3p / 4) is lower assumption would be difficult to hold in a number of cases. The than the price p, so no trade will take place at any possible expected quality of a product is often a subjective property, and equilibrium. the market's average real quality may well be unknown, or even Wilson (1979, 1980) argued that markets with adverse unobservable. Even if the average quality were objective, selection might be characterized by multiple stable equili- observable, and commonly known, it is not clear that every briums. However, some years later, Rose (1993) indicated that potential buyer would use it as an unequivocal indicator to the existence of multiple equilibriums depends critically on the determine his or her own expected quality. In this context, this distribution of quality, and that multiple equilibriums are paper assumes that buyers do not form quality expectations highly unlikely for most standard probability distributions. based on the average quality of the items in the market, but Hendel and Lizzeri (1999) studied the interactions between based on their own past experience, and potentially influenced new and used goods markets, and found that (in theory) the by the experiences of other buyers they may know. Tam (2005) used goods market would not shut down when these inter- explores the extent to which customers' expectations are shaped actions are considered; they then suggested that previous by experience in real markets. models overstated the distortions caused by adverse selection. The main, possibly striking, argument that this paper This article, similarly to Akerlof's famous case, shows that develops is that quality variability by itself can significantly buyers' incomplete information is sufficient to cause market damage a market if individual buyers form their quality failure, and in some cases, even to destroy a market. In contrast expectations on the basis of the quality of the specific items 860 S.S. Izquierdo, L.R. Izquierdo / Journal of Business Research 60 (2007) 858–867 they purchase.