The Supply of Quality on a Market for "Experience Goods"

Abstract

THIS PAPER is concerned with the analysis of markets for experience goods, that is, markets where consumers are imperfectly informed about the quality of the products they buy. Renewed interest in models of this kind was sparked off by Akerlof's seminal article Market for Lemons in I97o.1 He showed that in certain kinds of markets quality uncertainty on the part of consumers could lead to market failure in the form of an insufficient supply of high quality products, or even market breakdown (no trade takes place at all). The market Akerlof focused on to illustrate his point is the market for second hand cars. This is no accidental choice. The second hand car market is characterized by the fact that most suppliers appear on the market only once. This means that they do not have the possibility to build up reputations or goodwill with the consumers. This restriction is of some importance. The two factors leading to market failure in the presence of imperfectly informed consumers are (i) moral hazard and (2) adverse selection.2 Moral hazard arises from the fact that if the producers' sales volume is totally independent of the quality of the products they sell, they will maximize profits by supplying only cheap low cost products. Adverse selection arises from the fact that suppliers of the cheapest low quality products will drive from the market any producer who for whatever reason wishes to supply higher quality products. The crucial assumptions giving rise to both of these sources of market failure are: (a) high quality products are more expensive to produce than low quality products, and (b) the sales volume of each supplier is independent of the quality he supplies. (As consumers cannot observe quality, the producer's choice of quality cannot have any influence on his sales volume.) In most real world situations suppliers stay on the market for considerably longer than one period. They then have the possibility to build up reputations or goodwill with the consumers. This is due to the following mechanism. While the consumers cannot directly observe a product's quality at the time of purchase, they may try to draw inferences about this quality from the past experience they (or others) have had with this supplier's products. The inferences will be of the kind: If a producer has supplied good quality in the past,