The Market for Lemons
Akerlof examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, which ultimately leaves goods that are found to be defective after purchase in the market, noted by the term 'lemon' in the title of the paper.
Thus the uninformed buyer's price creates an adverse selection problem that drives the high-quality cars from the market.
Akerlof's paper shows how prices can determine the quality of goods traded on the market.
In 2001, Akerlof, along with Michael Spence, and Joseph Stiglitz, jointly received the Nobel Memorial Prize in Economic Sciences, for their research on issues related to asymmetric information.
A used car is one in which ownership is transferred from one person to another, after a period of use by its first owner and its inevitable wear and tear.
Because many important mechanical parts and other elements are hidden from view and not easily accessible for inspection, the buyer of a car does not know beforehand whether it is a peach or a lemon.
The result is that a market in which there is asymmetric information with respect to quality shows characteristics similar to those described by Gresham's law: the bad drives out the good.
(Although Gresham's principle applies more specifically to exchange rates, modified analogies can be drawn.)
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 indistinguishable 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.
As a consequence of the mechanism described in this paper, markets may fail to exist altogether in certain situations involving quality uncertainty.
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.
George E. Hoffer and Michael D. Pratt state that the "economic literature is divided on whether a lemons market actually exists in used vehicles".
[6] It has profoundly influenced virtually every field of economics, from industrial organisation and public finance to macroeconomics and contract theory.
A lemon market will be produced by the following: It is possible to generalize the reasoning in Akerlof's paper.
Furthermore, the equation for a buyer's expected utility implies that the equilibrium price in an informationally symmetric market is:
Depending on the type of car he owns, the seller has a differing decision rule based on the offer price
It is also assumed that, for both peaches and lemons, sellers are willing to accept a price lower than the full value of the car:
The beauty of this example is that it illustrates how product quality can collapse in a market with asymmetric information.
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.
Akerlof's original model has been developed by adjusting certain parameters to better represent the real world markets.
Akerlof limited the market to fixed buyers and sellers, disregarding the possibility that agents are able to interchange their position, with low transaction costs.
By changing the parameters of the model this study's findings conclude that the lemon principle does not hold.
[9] Zavolokina, Schlegel and Schwabe incorporate the benefits of modern technology into the model as blockchain is able to solve issues relating to the asymmetry of information.
The information would have to be understandable to consumers with no car expertise to be an effective mechanism for decision making.
[11] This is also applicable when employees apply for jobs as employers may be hesitant or decide not to hire workers with previous work experience in the specific field, resulting in those who do not have prior experience or are new to the workforce to be denied by employers.
Health insurance also falls into the consideration of adverse selection where healthy individuals with no family history of medical concerns may choose not to purchase health insurance as they don't feel the need to pay the premium, where other individuals with pre-existing conditions or a family history of medical issues are likely to purchase health insurance.
Insurance companies have extensive application processes in place to protect themselves against the market asymmetric information.
Health concerns and age-related illnesses will likely develop as an individual gets older, so insurance premiums are increased with age.
