Market Failure Caused by Quality Uncertainty

Summary

The classical argument used to explain why markets can fail when there is product quality variability (e.g. the used car market) relies heavily on the presence of asymmetric information —i.e. there must exist some reliable quality indicators that can be observed by sellers, but not by buyers. Using computer simulation, this paper illustrates how such market failures can occur even in the absence of asymmetric information. The mere assumption that buyers estimate the quality of the product they buy using their past experience in previous purchases is enough to observe prices drop, market efficiency losses, and systematic underestimation of actual product quality. This alternative explanation is shown to be valid for a very wide range of learning rules and in various market contexts.