Akerlof’s Lemons

Efficient markets rely on complete information to succeed, while information asymmetries can create a market collapse. As was the case, one year ago, when my wife and I bought our first used car. Sixty days and one catastrophic break down later, I was reviewing Akerlof’s “Market for Lemons,” a work for which he received the Nobel prize in 2001. Lemons described a market where buyers and sellers had different information about the quality of used cars. The result was a complete market break down, a situation where no trade would take place.

When buyers are unable to discern the true quality of a good, they are unwilling to pay a premium for goods that actually are of quality. Producers are now unwilling to supply quality goods to the market, which creates a market of only poor goods. More specifically, buyers are willing to pay a price equal to the average quality of the goods. Any good whose quality is above average will not be supplied to the market. The market now contains only goods with average or below quality. While buyers cannot directly observe quality, they are aware that the departure of quality goods will lower the average quality of the remaining set. Buyers realize that average quality in the market will always lie below any given price, resulting in no trades taking place.

Do I believe the pre-owned car industry is a lemons market? No. However, I do believe there are many markets where information is not complete and uncertainty exists regarding quality. Consequently, these markets suffer and good products are driven out by lemons. So, during this 4th quarter shopping binge, look for products offering definite guarantees and full disclosure of information. And be wary of late night infomercials promising quality wares, because the market may be slowly collapsing.

Akerlof, George A. “The Market for ‘Lemons’: Quality Uncertainty and The Market Mechanism.” The Quarterly Journal of Economics, 84, no. 3 (1970), 488-500.