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Chapter Review Chapter 15: Imperfect Information in the Product Market

  1. The basic competitive model assumes that participants in the market have perfect information about the goods being bought and sold and their prices. In the real world, information is often imperfect. Economists have modified the basic model so that it includes a number of limitations on information.
  2. A problem of adverse selection may arise when consumers cannot judge the true quality of a product. As the price of the good falls, the quality mix changes adversely, and the quantity demanded at a lower price may actually be lower than at a higher price.
  3. Producers of high-quality products may attempt to signal that their product is better than those of competitors; for instance, they may provide better warranties.
  4. When consumers judge quality by price, they may agree on some price that offers the best value. Firms will have no incentive to cut prices below this "best value" price, even when, at this price, the amount they would be willing to supply exceeds demand. As a result, the market can settle on an equilibrium with an excess supply of goods.
  5. When there is perfect information, private property and prices supply the correct incentives to all market participants. When information is imperfect and incentives are not correct, two methods of adjusting them are to employ contracts with contingency clauses and to rely on reputation. For firms to have an incentive to maintain a good reputation, they must earn profits by doing so. Thus equilibrium price exceeds marginal cost. (Reputation may also serve as a barrier to entry.)
  6. Costly search may lead to price dispersion and imperfections of competition as each firm faces a downward-sloping demand curve.
  7. Advertising attempts to change consumers' buying behavior, either by providing relevant information about prices or characteristics, by using persuasion, or both.
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