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Akerlof: The market for lemons

Disclaimer. Don't rely on these old notes in lieu of reading the literature, but they can jog your memory. As a grad student long ago, my peers and I collaborated to write and exchange summaries of political science research. I posted them to a wiki-style website. "Wikisum" is now dead but archived here. I cannot vouch for these notes' accuracy, nor can I even say who wrote them. If you have more recent summaries to add to this collection, send them my way I guess. Sorry for the ads; they cover the costs of keeping this online.

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).

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).


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Tags

Akerlof, George (author)Political ScienceGame TheoryInformationPrincipal-AgentTrustInstitutionsOrigins of InstitutionsDevelopment

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