Akerlof: The market for lemons

Akerlof. 1970. The market for lemons: Quality uncertainty and the market mechanism. Quarterly Journal of Economics 84:488-500.

In Brief

Imagine that owners of lemons are willing to sell for $1000 and owners of plums are willing to sell for $2000. Imagine that purchasers are willing to pay up to $1200 for a lemon and up to $2400 for a plum. Assume that sellers know what kind of car they have, but buyers can't tell. All buyers know is that half of all used cars are lemons. Therefore, based on the expected probability that a given car is a lemon, they will pay only up to $1800 for any car (1/2*1200 + 1/2*2400). But plum owners aren't willing to sell for only $1800, so only lemon owners will sell. The logical conclusion is that only the lemons will be sold, and the equilibrium price will be between $1000 and $1200. The mere presence of inferior goods destroys the market for quality goods (an externality problem) when information is imperfect. Plum owners need some way of signaling their car's quality.

Possible market solutions: warranties/guarantees (shared risk), iterated interaction (brand names, chains), certification (diplomas, JD Powers, credit reporting). Possible non-market solutions: government certification agencies (FDA), licensing.

To put this in terms of X and Y, asymmetric information (X) leads to adverse selection (Y).

• Asymmetric information: The buyer and seller have unequal information about the vehicle's type.
• Adverse selection: The buyer risks buying a car that is not of the type he expects--e.g. buying a lemon when he thinks he is buying a plum.

Basically, the "lemon principle" is that bad cars chase good ones out of the market. This is related to Gresham's law (bad money drives out good money through mechanism of exchange rates).