The Market for "Lemons" 🍋
The Market for "Lemons": Quality Uncertainty and the Market Mechanism
Author: George A. Akerlof
Year: 1970
The following is my summary of George A. Akerlof's paper. If you have access to it, you should definitely read it! I don't go into detail on the utility functions he uses in this paper, but it's really interesting (I was up all night playing with them in Desmos) and this is one of the more famous papers in modern economics. Also, my summary might not be fully correct. I am doing this as an exercise for myself, and potentially to find other people who love research :). Key term definitions are mine.
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Summary:
It’s scary to buy something when you have no way of assessing its quality. Consumers in many markets share this fear, from grocery shoppers at a market to health insurance companies assigning rates to prospective subscribers. When you don’t have any information about the quality of a product, you have to rely on your knowledge of the average quality in the market and the price of the product. If that price seems too good to be true, you probably won’t buy that product. In The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, George Akerlof explores this type of uncertainty and the market failure it causes through a hypothetical used car market.
Akerlof classifies cars as either new or used and as either good or lemon (bad). New cars are more likely to be good, but can also be lemons. Used cars are more likely to be lemons, but can also be good. When someone buys a new car, they don’t know whether it’s good or a lemon. By the time they’re ready to turn around and sell it as a used car, they’re pretty aware of its quality. The prospective used car buyers now lack the information on the car's quality. This is an asymmetric information problem!
If you’re selling a used car that you know is good, you want to sell it for the price of a good new car. But, because buyers can’t distinguish between used good cars and used lemons, they are hesitant to pay the price of a good car. After all, if you’re selling a lemon for the price of a good car, you can turn around and buy a new car that’s more likely to be good. So, buyers of used cars have reason to fear an upcharge, and are unwilling to pay new car prices for cars likely to be lemons. As a seller, this means you have to lower the price you’re demanding for your used car.
As a used car buyer, you see a car selling for a price close to that of a lemon. You might ask yourself why someone would sell a good car for that price. It’s not like they’re going to be able to buy another good car with their proceeds. So, you are unwilling to buy the used car because, based on the data available to you, it must be a lemon. Eventually, the market will disappear because the lemons drive out the good cars (as Akerof says, “Gresham’s law [...] is instructive, but not complete” (Akerlof 1970)). The consumers don’t know whether a car is good or not, but the price must get lower, dragging average quality down with it. The average quality is observable by prospective buyers, and when it gets low enough, the market dies. Such is the consequence of asymmetric information.
Key Terms:
Finger Exercise A finger exercise is a simple version of a scenario economists use to play around with new ideas. Here, the used car market is a finger exercise for the asymmetric information problem in markets.
Asymmetric Information Information asymmetry comes from a difference in information between people. Basically, one party knows something the other doesn't.
Gresham's Law “Bad money drives out good.” Originally, Gresham’s law described coin hoarding. If a society is using all solid-gold coins, everyone is happy. When they start running out of gold, they might start minting coins of the same monetary value using only 50% gold. People will start hoarding the solid gold coins because they possess more intrinsic value, and only the “bad money” will remain in circulation.
For a modern example, Cuba charges a fee for using American dollars. The dollar is more powerful than the peso, but because of the law the dollar has an extra cost. People use the dollar less, effectively hoarding that “good money” and leaving the peso (the “bad currency”) in circulation.
Utility Function A function describing the utility derived from some combination of variables. The goal is usually to reach the max value for utility.
Von Neumann-Morgenstern Maximizer of Expected Utility Von Neumann-Morgenstern maximizers will choose outcomes that maximize utility under risky situations
Arrow-Debreu Model In the Arrow-Debreu model, the world consists of households, firms, and the market that connects them. Households consume products to maximize their utility. Firms sell products to maximize profits. The A-D model states that the market (which has no motivation of its own) will reach an equilibrium at the market-clearing price.
Uncertainty in the A-D Model Say you have a product so that in outcome A, the product is good, and in outcome B, it’s a lemon. Also, say that trading for that product closes before either outcome is known. In the A-D model, this uncertainty is handled by treating the product in outcome A as a completely different product from the one in outcome B.
In a prediction market, for example, tokens are traded until some agreed-upon market-closing time. Then, everyone waits to see whether an event occurs to find out how much their tokens are worth. Under the A-D model, a single token is treated like two separate tokens: a winning token (outcome A) and a losing token (outcome B). This makes it easier to hedge your bets because you know your net income in either outcome.
Akerlof, G. A. (1970). The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84(3), 488–500.
