The Market for Lemons

"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper by the economist George Akerlof. It discusses information asymmetry, which occurs when the seller knows more about a product than the buyer. A lemon is an American slang term for a car that is found to be defective only after it has been bought. Akerlof, Michael Spence, and Joseph Stiglitz jointly received the Nobel Memorial Prize in Economic Sciences in 2001 for their research related to asymmetric information. 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 Used Cars uncertainty problem

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 ("cherries") 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 cherry 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 asymmetrical information with respect to quality shows characteristics similar to those described by Gresham's Law: the bad drives out the good (although Gresham's Law applies to a different situation).

"Lemon market" effects have also been noted in other markets, such as used computers^{[citation needed]} . There are also parallels in the insurance market, where, unless those least likely to need insurance (i.e., those least likely to get in accidents) are forced to buy insurance, it is those most likely to need insurance compensation who tend most to buy insurance.

Statistical abstract of the problem

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 which could be supplied to the market is therefore 1/2. There are a large number of buyers looking for cars who are prepared to pay their reservation price of $\frac 3 2 q$ 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 $\frac 3 2 q$, 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 $\frac 3 2 q_{avg}$, 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) = $\frac 3 4 p$. 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.

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 death 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,^{[dubious – discuss]} 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 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.

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.^[1]

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 was correct, then no goods could be traded. Only on the 4th attempt did the paper get published in Quarterly Journal of Economics.^[2] Today, the paper is one of the most-cited papers in modern economic theory (more than 8,530 citations in academic papers as of May 2011),^[3] and has profoundly influenced economic thinking in virtually every field of economics, from industrial organisation and public finance to macroeconomics and contract theory.

Criteria

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)

Impact on markets

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

“

The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.

”

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 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 salesman 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.^[4]

In any case, the "used car" scenario is clearly intended as an allegory, meant to clearly illustrate an idea; and not as a literal statement concerning the actual business of car sales or any real-life individuals and companies engaged in such a business.

See also

• Highest quality is lowest cost
• Adverse selection
• Death spiral (insurance)
• Tragedy of the commons

References

1. ^ Hoffer, George E.; Pratt, Michael D. (1987). "Used vehicles, lemons markets, and Used Car Rules: Some empirical evidence". Journal of Consumer Policy 10 (4): 409–414. doi:10.1007/BF00411482. 
2. ^ Writing the “The Market for ‘Lemons’”: A Personal and Interpretive Essay by George A. Akerlof
3. ^ "Citations of Akerlof: The Market for Lemons: Quality Uncertainty and the Market Mechanism". Google Scholar. http://scholar.google.de/scholar?cites=8622278700871890196&as_sdt=5,24&sciodt=0,24&hl=en&num=100. Retrieved 2011-05-27. 
4. ^ Lemons and the Nobel Prize http://mises.org/story/801

Further reading

• Akerlof, George A. (1970). "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism". Quarterly Journal of Economics (The MIT Press) 84 (3): 488–500.. 

External links

• The Market for Lemons: The Good, the Bad and the Ugly