The Market for Lemons:

Quality Uncertainty and the

Market Mechanism
George A. Akerlof, (1970). Quarterly
Journal of Economics, 84 (3): 488500
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 individuals 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!

Greshams 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 Greshams 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 Greshams 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 + x
(M is consumption of other goods, x is
quality of ith car)
Group2: U2=M + (3/2)x

Asymmetrical Information
Assumptions:
Both traders utility maximizers
Group1 has N cars with uniformly
distributed quality x, 0x2, Group2 has
no cars
Price of M (other goods) is unity

Asymmetrical Information
Group1 income = Y1, Group2s = Y2
Demand by group1 or type1 traders
D1 = Y1/pwhen u/p>1
D1 = 0
when u/p<1

Supply offered by type1 traders

S2=pN/2 p2

With average quality

U=p/2

Asymmetrical Information
Demand by group2 or type2 traders
D2 = Y2/p
D1 = 0

when 3u/2>p
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, 0x2
Supply:
S(p)=N
S(p)=0

p>1
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 doesnt the price rise to match the
risk?
Akerlofs 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)