The Market for Lemons

From Academic Kids

"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a paper by George Akerlof written in 1970 that established the fundamentals of asymmetrical information theory. Akerlof, a professor at the University of California, Berkeley, won the Nobel Prize of Economics in 2001 for his research.

The paper by Akerlof describes how the interaction between quality heterogeneity and asymmetrical information can lead to the disappearance of a market where guarantees are indefinite.

In this model, as quality is undistinguishable ex ante by the buyer (due to the asymmetry of information), incentives exist for the seller to pass off a low-quality good as a higher-quality one. The buyer, however, takes this incentive into consideration, and takes the quality of the good to be uncertain. Only the average quality of the good will be considered, which in turn will have the side effect that goods that are above average in terms of quality will be driven out of the market. This mechanism is repeated until a no-trade equilibrium is reached.

As a consequence of the mechanism described in this paper, markets may fail to exist altogether in certain situations involving quality uncertainty. Examples include the market for used cars, the dearth of formal credit markets in developing countries and the unavailability of health insurance for the elderly (that is, in the absence of government programs such as Medicare (United States)).

A simple exposition of the model: The automobiles market

The paper describes the second-hand market for cars as an example of the more general problem of quality uncertainty. There are good used cars, and defective used cars ("lemons"). The buyer of a car does not know, ex ante, whether it is a good car or a lemon. So the buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of car of known average quality. This means that the owner of a good used car will be unable to get a high enough price for it to make selling the car worthwhile. Therefore, good car owners will not place their cars on the used car market. The withdrawal of good cars reduces the average quality of cars on the market, causing buyers to revise downward their expectations for any given car. This, in turn, motivates the owners of moderately good cars not to sell, and so on. The result is that a market in which there is asymmetrical information with respect to quality shows characteristics similar to those described by Gresham's Law: the bad drives out the good.

Suppose we can use some number, q to index the quality of used cars, where q is uniformally distributed over the interval [0,1]. The average quality of a used car on the market is therefore 1/2.

There are a large number of buyers looking for cars who are prepared to pay their reservation price of (3/2)q for a car that is of quality q. There are also a large number of sellers who are prepared to sell a car of quality q for the price q. If quality were observable, the price of used cars would therefore be somwhere between q and (3/2)q, and the cars would be sold and everyone would be perfectly happy.

If the quality of cars is not observable by the buyers, then it seems reasonable for them to estimate the quality of a car offered to market using the average quality of the cars. Based on this estimation, the willingness to pay for any given car will therefore be (3/2)q.

Now, assume that the equilibrium price in the market is some price, p, where p>0. At this price, all the owners of cars with quality less than p will want to offer their cars for sale. Since quality is uniformally distributed over the interval from 0 to p, the average quality of the cars offered for sale at p will be p/2.

We know however that for an expected quality of p/2, buyers will only be willing to pay (3/2)(p/2) = (3/4)p. Therefore we can conclude that no cars will be sold at p. Because p is any arbitrary positive price, it is shown that no cars will be sold at any positive price at all. The market for used cars collapses when there is asymmetric information.

The term "lemon," did not enter the language of economics as a result of this paper. Instead, it came from the famous "Lemon" Volkswagen advertisement of the 1960s.


External links

ja:レモン市場 fr:The Market for Lemons


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