The Market for “Lemons”: Quality
Uncertainty and the Market
Mechanism
Akerlof (1970)
1
Introduction
• In many markets where buyers use a market statistic
to judge quality, there is an economic incentive for
sellers to market poor quality products, since
economic returns for good quality accrue mainly to
the group (and not to the individual)
• Thus, there tends to be a reduction in average quality
of goods and also a reduction in the size of the market
2
The Model
• Akerlof (1970) uses the automobiles market (specifically
the used car market) for its concreteness and ease in
understanding
• An individual’s new car may be good or it may be a
lemon (bad quality car), the individual does not know
when initially purchasing the new car
• After a length of time, the owner has a better estimate
of the quality of the car, based on first‐hand experience
with a particular car
3
The Model
Asymmetrical Information
• the sellers have more information about the quality of a
car than the buyers
• But good cars and bad cars must sell at the same price –
since it is impossible for a buyer to tell the difference
between a good car and a lemon
• Thus, an owner of a good car cannot receive its true
economic value, and the owner is locked in
• Most cars traded are “lemons”, and good cars may
not be traded at all!
4
The Model
• A used car cannot have the same valuation as a new car
because it would be advantageous to trade a lemon at
the price of a new car and then buy the new car with
the higher probability of being a good car
The lemons drive out the good cars
• Gresham’s Law – bad money drives out good money
(exchange rate constant)
• Bad cars drive out the good cars because they sell at the
same price and in addition, the buyer cannot tell the
difference between a good and bad car but the seller
can (has at least a better idea)
5
The Model
Assumptions:
1. 4 kinds of cars; new and used, good and bad (‘lemons’)
2. A buyer of a new car assigns a probability q that it is a good car, and (1‐q) that
it is a ‘lemon’
out of the cars produced the proportion of good cars produced is q and the
proportion of lemons produced is (1‐q)
3. demand for used cars depends on 2 variables – price (p) and average quality
of used cars (µ): Q=D(p,µ)
4. Supply and average quality will depend on price: µ=µ (p) and S=S(p)
5. Equilibrium: S(p) = D(p, µ(p))
6
Asymmetrical Information: Model
• Such an example can be derived from utility theory:
6. Assume 2 groups of traders, with linear utility and
constant MU
• Group1 utility function: ୀ
(M is consumption of other goods, x is quality of ith car)
• Group2: ୀ
7
Asymmetrical Information: Model
• Further Assumptions:
7. Both traders utility maximizers
8. Group 1 has N cars with uniformly distributed quality
x, 0≤x≤2, Group 2 has no cars
9. Price of M (other goods) is unity
8
Asymmetrical Information : Model
10. Group 1 income = Y1, Group 2’s = Y2
• Demand by type 1 traders
D1 = Y1/p when µ/p>1
D1 = 0 when µ/p<1
• Supply offered by type 1 traders
S1=pN/2 p≤2 …1
• With average quality
µ=p/2 …2
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Asymmetrical Information: Model
• Demand by type 2 traders
D2 = Y2/p when 3µ/2>p
D2 = 0 when 3µ/2<p
• Supply offered by type2 traders
S2 =0
• Thus, total demand is:
D(p, µ) = (Y2 + Y1)/p if p<µ
D(p, µ) = Y2/p if µ<p<3µ/2
D(p, µ) = 0 if p>3µ/2
• However, average quality at price p is p/2 and therefore at no
price will trade take place. This is in spite of the fact that at any
given price between 0 and 3 there are type 1 traders willing to
sell at a price type 2 traders are willing to pay.
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Symmetric Information
• Assume quality of cars uniformly distributed, 0≤x≤2
• Supply:
S(p)=N p>1
S(p)=0 p<1
• Demand:
D(p)=(Y2 + Y1)/p p<1
D(p)= (Y2 /p) 1<p<3/2
D(p)=0 p>3/2
• Equilibrium
p=1 if Y2 <N
p=Y2/N if 2 Y2 /3<N<Y2
p=3/2 if N< 2Y2 /3
• If N<Y2, there is a gain in utility over the case of asymmetric information of
N/2. If N>Y2, where income of type2 traders is insufficient to buy all N
automobiles, there is a gain in utility of Y2 /2 units.
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Examples and Applications
A. Insurance
• People over 65 have difficulty buying medical insurance:
Why doesn’t the price rise to match the risk?
• As price rises those that insure themselves are those that
know they need it, and average medical condition of
applicants deteriorates as price rises – no insurance is sold at
any price
• Group insurance: offered to employees (picks out healthy)
• Argument for medicare: any price offered will attract to
many “lemons” (analogous argument to publicly financed
roads)
12
Examples and Applications
• Other examples of Lemon principle:
• B. The Employment of Minorities
• C. The Costs of Dishonesty
• D. Credit markets in underdeveloped countries
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Counteracting Institutions
• Institutions that counteract the effects of quality
uncertainty
Guarantees‐to ensure buyer of some normal
expected quality
Brand‐names‐not only indicate quality but also give a
form of retaliation by curtailing future purchases
Chains (hotels, restaurants)
Licensing of physicians, barbers and lawyers
etc.(Certification)
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