corners the market

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.

Akerlof, Michael Spence, and Joseph Stiglitz jointly received the Nobel Memorial Prize in Economic Sciences in 2001 for their research related to 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 dearth of formal credit markets in developing countries, and the difficulties that the elders 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.

Ironically, 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, 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 wines (beyond just safety and freshness issues). 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. However, a definition of 'highest quality' for food and wine eludes providers. Thus, a large variety of better quality and higher priced restaurants are supported.

Used cars: a "lemons market"

Akerlof's paper uses the market for used cars as an example of the problem of quality uncertainty. There are good used cars and defective used cars ("lemons"). The buyer of a car does not know beforehand whether it is a good car 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 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).

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 on 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 (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 (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 (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) = (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. p

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.

Criteria for a lemon market

A lemon market will be produced by the following:

Asymmetry of information

no buyers can accurately assess the value of a product through examination before sale is made
all sellers can more accurately assess the value of a product prior to sale

An incentive exists for the seller to pass off a low quality product as a higher quality one
Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)
Either there exist a continuum of seller qualities OR the average seller type is sufficiently low (i.e. buyers are sufficiently pessimistic about the seller's quality)
Deficiency of effective public quality assurances (by reputation or regulation)
Deficiency of effective guarantees / warranties

Impact of "lemons" 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.

Rejections and acceptance of the paper

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. Today, the paper is one of the most-cited papers in modern economic theory (more than 4600 citations in academic papers as of August 2008).

Lemon 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.