"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper by the economist
George AkerlofGeorge Arthur Akerlof is an American economist and Koshland Professor of Economics at the University of California, Berkeley. He won the 2001 Nobel Prize in Economics . His father was Swedish and his mother a Jewish/German-American. Akerlof graduated from the Lawrenceville School and received...
. It discusses information asymmetry, which occurs when the seller knows more about a product than the buyer. Akerlof,
Michael SpenceAndrew Michael Spence is an American-born, Canadian-raised economist and recipient of the 2001 Nobel Prize in Economics, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. He conducted this research while at Harvard...
, and Joseph Stiglitz jointly received the
Nobel Memorial Prize in Economic SciencesThe Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics , is an award for outstanding contributions to the science of economics and is generally considered one of the most prestigious awards for that science. The official name is the Sveriges Riksbank...
in 2001 for their research related to asymmetric information. Akerlof's paper uses the
marketA market is any one of a variety of different systems, institutions, procedures, social relations and infrastructures whereby persons trade, and goods and services are exchanged, forming part of the economy. It is an arrangement that allows buyers and sellers to exchange things...
for used
carAn automobile, motor car or car is a wheeled motor vehicle used for transporting passengers, which also carries its own engine or motor...
s as an example of the problem of quality uncertainty.
"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper by the economist
George AkerlofGeorge Arthur Akerlof is an American economist and Koshland Professor of Economics at the University of California, Berkeley. He won the 2001 Nobel Prize in Economics . His father was Swedish and his mother a Jewish/German-American. Akerlof graduated from the Lawrenceville School and received...
. It discusses information asymmetry, which occurs when the seller knows more about a product than the buyer. Akerlof,
Michael SpenceAndrew Michael Spence is an American-born, Canadian-raised economist and recipient of the 2001 Nobel Prize in Economics, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. He conducted this research while at Harvard...
, and Joseph Stiglitz jointly received the
Nobel Memorial Prize in Economic SciencesThe Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics , is an award for outstanding contributions to the science of economics and is generally considered one of the most prestigious awards for that science. The official name is the Sveriges Riksbank...
in 2001 for their research related to asymmetric information. Akerlof's paper uses the
marketA market is any one of a variety of different systems, institutions, procedures, social relations and infrastructures whereby persons trade, and goods and services are exchanged, forming part of the economy. It is an arrangement that allows buyers and sellers to exchange things...
for used
carAn automobile, motor car or car is a wheeled motor vehicle used for transporting passengers, which also carries its own engine or motor...
s as an example of the problem of quality uncertainty. There are good used cars and defective used cars ("lemons"), but because of asymmetric information about the car (the seller knows much more about the problems of the car than the buyer), the buyer of a car does not know beforehand 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 a car of known average quality. This means that the owner of a good used car will be unable to get a high enough price to make selling that car worthwhile. Therefore, owners of good cars will not place their cars on the used car market. This is sometimes summarized as "the bad driving out the good" in the market. "Lemon market" effects have also been noted in other markets, such as used computers and the online dating "market" . There are also parallels in the insurance market, where, unless a mandate for insurance is in place, it is those most likely to need insurance compensation (i.e., those most likely to get in accidents) who tend most to buy insurance, eliminating the advantage of diffusing risk that insurance is supposed to provide (
adverse selectionAdverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or customers are more likely to be...
).
Asymmetric information
The paper by Akerlof describes how the interaction between quality heterogeneity and asymmetric information can lead to the disappearance of a market where guarantees are indefinite. In this model, as quality is undistinguishable beforehand by the buyer (due to the asymmetry of information), incentives exist for the seller to pass off low-quality goods as higher-quality ones. The buyer, however, takes this incentive into consideration, and takes the quality of the goods to be uncertain. Only the average quality of the goods 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 given in Akerlof's paper include the market for used cars, the dearth of formal credit markets in developing countries, and the difficulties that the elderly encounter in buying health insurance. However, not all players in a given market will follow the same rules or have the same aptitude of assessing quality. So there will always be a distinct advantage for some vendors to offer low-quality goods to the less-informed segment of a market that, on the whole, appears to be of reasonable quality and have reasonable guarantees of certainty. This is part of the basis for the idiom, buyer beware.
There is no reciprocal danger of a market for a good product collapsing in this manner when the asymmetry is in favour of the buyer, that is to say, when the buyers can assess more accurately the quality of the products than the sellers. In this case, regular market forces of supply and demand will prevail, the sellers will get the highest price paid, and the trend will be to weed out products with prices in excess of their quality. This is likely the basis for the idiom that an
informed consumerThe concept of the informed consumer is a fundamental one in the law of the European Union. Since the general Resolution of 1975, one of the primary objectives of the European Community, and then the European Union, has been the provision of information to consumers...
is a better consumer. An example of this might be the subjective quality of fine food and wine. Individual consumers know best what they prefer to eat, and quality is almost always assessed in fine establishments by smell and taste before they pay. That is, if a customer in a fine establishment orders a lobster and the meat is not fresh, he can send the lobster back to the kitchen and refuse to pay for it. However, a definition of 'highest quality' for food eludes providers. Thus, a large variety of better quality and higher priced restaurants are supported.
Both the
American Economic ReviewThe American Economic Review is a peer-reviewed journal of economics published quarterly by the American Economic Association. First published in 1911, it is considered one of the most prestigious journals in the field. The current editor is Robert A. Moffitt of Johns Hopkins University...
and
The Review of Economic Studies rejected the paper for "triviality", while the reviewers for
Journal of Political EconomyThe Journal of Political Economy is an academic journal run by economists at the University of Chicago and published every two months by the University of Chicago Press. The journal publishes articles in both theoretical economics and empirical economics...
rejected it as incorrect, arguing that if this paper was correct, then no goods could be traded. Only on the 4th attempt did the paper get published in
Quarterly Journal of EconomicsThe Quarterly Journal of Economics, or QJE, is an economics journal published by the MIT Press and edited at Harvard University's Department of Economics. Its current editors are Robert J. Barro, Elhanan Helpman and Lawrence F. Katz...
. Today, the paper is one of the most-cited papers in modern economic theory (more than 5,800 citations in academic papers as of July 2009).
Used cars
Akerlof's paper uses the
marketA market is any one of a variety of different systems, institutions, procedures, social relations and infrastructures whereby persons trade, and goods and services are exchanged, forming part of the economy. It is an arrangement that allows buyers and sellers to exchange things...
for used
carAn automobile, motor car or car is a wheeled motor vehicle used for transporting passengers, which also carries its own engine or motor...
s as an example of the problem of quality uncertainty. A used car is one in which ownership is transferred from one person to another. There are good used cars ("cherries")and defective used cars ("lemons"). The buyer of a car does not know beforehand 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 a car of known average quality. This means that the owner of a good used car will be unable to get a high enough price to make selling that car worthwhile. Therefore, owners of good cars 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 LawGresham's law is commonly stated: "Bad money drives out good", but more accurately stated: "Bad money drives out good under legal tender laws."...
: the bad drives out the good (although Gresham's Law applies to a different situation).
Suppose we can use some number, q to index the quality of used cars, where q is uniformly 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 priceIn microeconomics, the reservation price is the maximum price a buyer is willing to pay for a good or service; or, conversely, the minimum price at which a seller is willing to sell a good or service...
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 somewhere 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 all cars. Based on this estimation, the willingness to pay for any given car will therefore be (3/2)(q_avg), where q_avg is the average quality of all the cars. 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 again, quality is uniformly distributed over the interval from 0 to this p, the average quality of the cars offered for sale at p will be worth only p/2. We know however that for an expected quality worth 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.
George E. Hoffer and Michael D. Pratt state that the “economic literature is divided on whether a lemons market actually exists in used vehicles." The authors’ research supports the hypothesis that “known defects provisions,” used by US states (e.g., Wisconsin) to regulate used car sales have been ineffectual, because the quality of used vehicles sold in these states is not significantly better than the vehicles in neighboring states without such consumer protection legislation.
Criteria
A lemon market will be produced by the following:
- Asymmetry of information, in which no buyers can accurately assess the value of a product through examination before sale is made and all sellers can more accurately assess the value of a product prior to sale
- An incentive exists for the seller to pass off a low quality product as a higher quality one
- Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)
- Either there exist a continuum of seller qualities OR the average seller type is sufficiently low (i.e. buyers are sufficiently pessimistic about the seller's quality)
- Deficiency of effective public quality assurances (by reputation or regulation and/or of effective guarantees / warranties)
Impact on markets
The article draws some conclusions about the cost of dishonesty in markets in general:
Laws in the United States
Five years after Akerlof's paper was published, The United States enacted a federal "lemon law" (the
Magnuson-Moss Warranty ActThe Magnuson-Moss Warranty Act is a United States federal law . Enacted in 1975, it is the federal statute that governs warranties on consumer products....
) that protects citizens of all states. There are also state laws regarding "lemons" which vary by state and may not necessarily cover used or leased vehicles. The rights afforded to consumers by "lemon laws" may exceed the warranties expressed in purchase contracts. These state laws provide remedies to consumers for automobiles that repeatedly fail to meet certain standards of quality and performance. "Lemon law" is the common nickname for these laws, but each state has different names for the laws and acts, which may also cover more than just automobiles. In California and federal law, "Lemon Laws" cover anything mechanical.
The federal "lemon law" also provides the warrantor may be obligated to pay your attorney fees if you prevail in a lemon law suit, as do most state lemon laws. If a car has to be repaired for the same defect four or more times and the problem is still occurring, the car may be deemed to be "a lemon." The defect must substantially hinder the vehicle's use, value or safety. Purchasers who knowingly purchase a car in "as is" condition accept the defects and void their rights under the "lemon law".
Criticism
Criticism for this theory stems from the fact that it ignores the fact that consumers themselves can seek ways to assure the quality of a car and that a used-car salesperson may work to maintain their reputation rather than pass off a "lemon".
Libertarians like
William L. AndersonWilliam L. Anderson is an author and an associate professor of economics at Frostburg State University in Maryland. He is also an adjunct scholar with the Mackinac Center for Public Policy as well as for the Ludwig von Mises Institute in Alabama....
oppose the regulatory approach proposed by the authors of the paper, observing that some used-car markets haven't broken down even without lemon legislation and that the lemon problem creates entrepreneurial opportunities for alternative marketplaces or customers' knowledgeable friends.
See also
- Highest quality is lowest cost
"Highest quality is lowest cost" is a Japanese manufacturing aphorism based on the premise that the highest quality manufacturer will earn a reputation that makes buyers prefer, price being reasonably similar, to buy its goods...
- Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or customers are more likely to be...
- Death spiral (insurance)
Death spiral is a term used to describe an insurance plan whose costs are rapidly increasing as a result of changes in the covered population. It is the result of adverse selection in insurance policies where lower risk policy holders choose to change policies or be uninsured.- Health Insurance...
- Tragedy of the commons
The tragedy of the commons refers to a dilemma described in an influential article by that name written by Garrett Hardin and first published in the journal Science in 1968...
External links