The Market for Lemons

Akerlof's paper uses the market for used cars as an example of the problem of quality uncertainty. It concludes that 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.

"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper, by the economist George Akerlof which examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind. A lemon is an American slang term for a car that is found to be defective only after it has been bought.

Suppose buyers can't distinguish between a high-quality car (a "peach") and a "lemon". Then they are only willing to pay a fixed price for a car that averages the value of a "peach" and "lemon" together (p_avg). But sellers know whether they hold a peach or a lemon. Given the fixed price at which buyers will buy, sellers will sell only when they hold "lemons" (since p_lemon < p_avg) and they will leave the market when they hold "peach" (since p_peach > p_avg). Eventually, as enough sellers of "peach" leave the market, the average willingness-to-pay of buyers will decrease (since the average quality of cars on the market decreased), leading to even more sellers of high-quality cars to leave the market through a positive feedback loop.

Thus the uninformed buyer's price creates an adverse selection problem that drives the high-quality cars from the market. Adverse selection is the market mechanism that leads to a market collapse.

Akerlof's paper shows how prices can determine the quality of goods traded on the market. Low prices drive away sellers with high-quality goods leaving only lemons behind. Akerlof, Michael Spence, and Joseph Stiglitz jointly received the Nobel Memorial Prize in Economic Sciences in 2001, for their research related to asymmetric information.

The paper

Thesis

A used car dealer with a low-priced used car

Akerlof's paper uses the market for used cars as an example of the problem of quality uncertainty. A used car is one in which ownership is transferred from one person to another, after a period of use by its first owner and its inevitable wear and tear. There are good used cars ("peaches") and defective used cars ("lemons"), normally as a consequence of several not-always-traceable variables, such as the owner's driving style, quality and frequency of maintenance, and accident history. Because many important mechanical parts and other elements are hidden from view and not easily accessible for inspection, the buyer of a car does not know beforehand whether it is a peach 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 carefully maintained, never-abused, 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 asymmetric information with respect to quality shows characteristics similar to those described by Gresham's Law: the bad drives out the good. (Although Gresham's principle applies more specifically to exchange rates, modified analogies can be drawn.) ^[1]

Statistical abstract of the problem

Akerlof considers a situation in which demand D for used cars depends on the cars price p and quality µ=µ(p) and the supply depends on price alone. ^[2] Economic equilibrium is given by S(p)=D(p,µ) and there are two groups of traders with utilities given by:

Where M is the consumption of goods other than automobiles, x the car's quality and n the number of automobiles. Let Y_i, D_i and S_i be income, demand and supply for group i. Assuming that utilities are linear, that the traders are Von Neumann–Morgenstern utility maximizers and that the price of other M goods is unitary, the demand D₁ for cars is Y₁/p if μ/p>1, otherwise null. The demand D₂ is Y₂/p if 3μ/2>p, otherwise null. Market demand is given by:

Group 1 has N cars to sell with quality between 0 and 2 and group 2 has no cars to sell, therefore S₁= pN/2 and S₂=0. For a given price p, average quality is p/2, and therefore D=0. The market for used cars collapses when there is asymmetric information.

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.

This is likely the basis for the idiom that an informed consumer 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.

Impact on markets

The article draws some conclusions about the cost of dishonesty in markets in general:

Critical reception

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.^[3]

Both the American Economic Review and the Review of Economic Studies rejected the paper for "triviality", while the reviewers for Journal of Political Economy rejected it as incorrect, arguing that, if this paper were correct, then no goods could be traded.^[4] Only on the fourth attempt did the paper get published in Quarterly Journal of Economics.^[5] Today, the paper is one of the most-cited papers in modern economic theory and most downloaded economic journal paper of all time in RePEC (more than 8,530 citations in academic papers as of May 2011).^[6] It has profoundly influenced virtually every field of economics, from industrial organisation and public finance to macroeconomics and contract theory.

Criticism

Criticism for this theory stems from literalism, and the inability to see that the car market is being used as an analogy for all markets with asymmetric information. Literalist critics note the fact that it ignores that consumers themselves can seek ways to assure the quality of a car and that a used-car salesperson may work to maintain his reputation rather than pass off a "lemon". The issue of reputation, however, would not apply to private individual sellers who do not intend to sell another car in the near future.

Libertarians, like William L. Anderson, 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.^[7]

Conditions for a lemon market

A lemon market will be produced by the following:

1. 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
2. An incentive exists for the seller to pass off a low-quality product as a higher-quality one
3. Sellers have no credible disclosure technology (sellers with a great car have no way to disclose this credibly to buyers)
4. Either a continuum of seller qualities exists or the average seller type is sufficiently low (buyers are sufficiently pessimistic about the seller's quality)
5. Deficiency of effective public quality assurances (by reputation or regulation and/or of effective guarantees/warranties)

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 Act) 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 that the warrantor may be obligated to pay the attorney fees of the party prevailng 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".

See also

• Adverse selection
• Confusopoly
• Death spiral (insurance)
• Highest quality is lowest cost
• Tragedy of the commons
• Transaction cost
• Transparency (market)
• Open data

References