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April 28, 2008

When Life Hands You Lemons, Create a Classroom Market Experiment

Bogachan Celen
Assistant Professor, Finance and Economics
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In our “Game Theory and Incentives in Business” course, Professor Paolo Siconolfi and I use experimental methods as an active teaching tool, simulating a strategic market environment in which students can actively participate.

In our most recent experiment, we simulated George Akerlof’s market for lemons (faulty used cars). In his paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Akerlof illustrates the failure of a market due to asymmetric information between sellers and the buyers.

For this experiment, we divided the class into two groups: buyers and sellers. Sellers were able to chose a price, quality grade and whether they wanted one or two units. The sellers were told the monetary costs of producing each of their units, and these costs depended on the quality grade: a higher quality grade meant a more expensive unit. Sellers did this all without knowing what their competitors chose.

After all seller decisions had been submitted, both prices and quality grades were provided to buyers. Buyers then were allowed to make purchases of at most one unit at the posted price.

Of course the purpose of all this is to make a profit, so the sellers are trying sell at a price above the cost of a unit and buyers are trying to buy at a price below the value of the unit.

This experiment had two treatments. In the first four rounds, the buyers were able to see the quality grades before they bought a product, whereas in the last four rounds the quality of the product was hidden.

Buying and selling grade-two units is the socially and individually optimal outcome (it maximizes the income for both buyers and sellers) and this was indeed the case in the first part of the experiment: the majority of the transactions involved grade-two units at approximately right prices, with very little excess supply or demand. (You can see the results in the figure below, where the theoretical demand and supply is given on the left hand side.)

However, when the quality became unknown, the buyers reacted to the possibility of buying low-grade products. In fact, in round five, only four transactions (out of a possible 10) took place. The sellers responded quickly to the demand and lowered the prices. The market quickly converged to the lowest possible price level, and only low-grade products were sold.

Some students were playing in groups, and we overheard them reacting to adverse selection and moral hazard effects in a way that proved Akerlof’s theory. Our students were masterful in understanding the incentive problems in the market.

Of course none of this could have worked without enthusiastic students. We were very lucky to have a select group who took the theory and experiments very seriously and brought their insights into the classroom.

We like to conduct these experiments before discussing key economic ideas and principles, and during the spring term we conducted a good number of them: the pervasive winner’s curse phenomenon in auctions; a persistent bubble in a limit-order market; failure of auction mechanisms in the existence of asymmetric information; behavioral considerations beyond rationality in a trust game; and many other phenomena that arise in strategic market environments. Besides giving us a chance to illustrate the shortcomings and teachings of these theories, we find that these experiments allow students to gain firsthand experience with market theories and encourage them to ponder the underlying questions and issues.


by Mehmet Murat Emirdag | April 29, 2008 at 3:55 PM

As a student who took that class this semester, I really enjoyed having these classroom experiments because it gave us the unique opportunity to test the theory in a real-life situation. Besides, the experiments were perfect platforms where we were able to observe the reaction of other players (namely our classmates) in real-time and re-consider our decision-making process in each specific business case.

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