The Market for “Lemons”:

Quality Uncertainty and the

Market Mechanism
George A. Akerlof, (1970). Quarterly
Journal of Economics, 84 (3): 488-
500
Group 1:
Meredith, Barclay, Woo-je, & Kumar
 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
 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
 The Model
An asymmetry in available information has
developed: 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

The result: Most cars traded are “lemons”,

and good cars may not be traded at all!
 “Gresham’s Law”
Akerlof (1970) suggests that bad cars drive out
lemons in much the same way that “bad money
drives out good money”

This is a reference to Gresham’s Law

Gresham (1519-1579)
lightened or worn coins traded at same value as coins
with more precious metal content
Precious metal content coins saved, “bad” coins left to be
traded

Akerlof stresses a difference: bad cars sell at same

price as good cars because of asymmetric
information, yet in Gresham’s law presumably
buyer and seller distinguish good from bad money
 Asymmetrical Information
Assume demand for used cars depends on
2 variables – price (p) and average quality
of used cars (u): Q=D(p,u)

Supply and average quality will depend on

price: u=u(p) and S=S(p)

Equilibrium: S(p) = D(p,u(p))

 Asymmetrical Information
Such an example can be derived from utility
theory: Assume 2 groups of traders

Group1 utility function: U1=M + Σx

(M is consumption of other goods, x is
quality of ith car)

Group2: U2=M + Σ(3/2)x

 Asymmetrical Information
Assumptions:

Both traders utility maximizers

Group1 has N cars with uniformly distributed

quality x, 0≤x≤2, Group2 has no cars

Price of M (other goods) is unity

 Asymmetrical Information
Group1 income = Y1, Group2’s = Y2

Demand by group1 or type1 traders

D1 = Y1/p when u/p>1
D1 = 0 when u/p<1

Supply offered by type1 traders

S2=pN/2 p≤2

With average quality

U=p/2
 Asymmetrical Information
Demand by group2 or type2 traders
D2 = Y2/p when 3u/2>p
D1 = 0 when 3u/2<p

Supply offered by type2 traders

S2=0

Thus, total demand is:

D(p,u) = (Y2 + Y1)/p if p<u
D(p,u) = Y2/p if u<p<3u/2
D(p,u) = 0 if p>3u/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 type1
traders willing to sell at a price type2 traders are willing to
pay.
 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 2Y2/3<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.
 Example 1: Insurance
People over 65 have difficulty buying medical
insurance: Why doesn’t the price rise to match the
risk?

Akerlof’s answer: 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)
 Example 2: Employment of Minorities
Employers may refuse to higher minorities for certain
jobs

Profit maximization – race may serve as a good statistic

for social background, quality of schooling, general job
capabilities

Good quality schooling-Substitute

Credibility of school must be good

Rewards for work in slum schools accrue to the group,

not to individuals
 Example 3: Costs of Dishonesty
Dishonest dealings tend to drive honest
dealings out of the market (same logic as
before: presence of people willing to offer
inferior goods tends to drive market out of
existence)

Cost of dishonesty not just that purchaser is

cheated, but that legitimate business is
driven out of business
 Example 4: Credit Markets in Underdeveloped Countries

Indian “managing agencies” are

generally classified by communal origin

Sources of finance are limited to local

communal groups that can use
communal or family ties to encourage
honest dealing
 Counteracting Institutions
Institutions that counteract the
effects of quality uncertainty

Guarantees
Brand-names
Chains (hotels, restaurants)
Licenses (meaning professional licensing
of doctors, lawyers, barbers, Ph,D.,
Nobel Prize)
 Conclusions
Akerlof (1970) provides a thorough treatment
of the effects of asymmetric information on
trading in markets (quality of products in
market, size and existence of market)

The last part of the article points out some

institutions that counteract the effects of
asymmetric information – this relates directly
to some areas in strategic management (i.e.
choice of governance form, principal-agent
problems)