Course Notes

Trading with Incomplete Information: Akerlofs Lemons Model

Rakesh Chaturvedi

Consider a seller of a used car and a potential buyer. We want to model how does the
uncertainty about the quality of the car affects trade between the two parties. There is
incomplete information in this setting as the buyer is uncertain about the quality of the car.
The seller, however, is certain about the quality. Quality is modeled as a one-dimensional
parameter t [0, 1]; t = 1 indicating a car with the highest quality and t = 0 indicating a
car with the worst quality possible. Quality affects both parties valuations of the car. In
particular, sellers valuation of a car of quality t is ts while the buyers valuation is tb .
Assume b > s . Both parties must decide whether or not to trade the car.
We model the trading situation as a Bayesian game.
1. the set of players N = {b, s}
2. the action sets Ab = As = { T , NT }
3. buyers uncertainty is modeled as a sellers type. In other words, we suppose that a seller
could be of any type ts Ts = [0, 1]. since the seller has no uncertainty about the quality,
the buyers type set is modeled as a singleton set tb Tb = {b}. A type profile is a vector
(tb , ts ) of buyers and sellers type.
4. each types beliefs about other players types is part of the specification.
(a) So we need to specify a buyers beliefs pb about the random variable (from buyers
perspective) ts . Mathematically, pb is just the distribution of the random variable ts . Suppose
ts is distributed as U [0, 1] so that pb (ts x) = x.
(b) we also need to specify for every type ts of the seller, his belief about the buyers type.
Since the seller has no uncertainty, this is simple. For every t [0, 1], ps (tb = b|ts = t) =
1.
5. we need to write the payoff function ui (a; b, t) i.e. payoffs of the buyer and the seller when
the action profile is a and the type profile is (b, t).

s
T NT
b T tb p, p 0, ts
NT 0, ts 0, ts

The strategy profile (b [b] = T, t Ts , s [t] = T ) which specifies a strategy for each type

1
of every player is a Bayesian Nash equilibrium (BNE) if



Et ub (T, T ); (b, t) Et ub (N T, T ); (b, t) and (1)



t Ts = [0, 1], us (T, T ); (b, t) us (T, N T ); (b, t) (2)

The above pair of inequalities are elaborated to

E[t]b p 0 and (3)

t Ts = [0, 1], p ts (4)

A sellers willingness to trade is an informative signal about his type. In particular, (4)
implies that the quality t ps . A rational buyer must incorporate this information when he
computes the expected quality in (3). In light of (4), (3) reduces to
p
E[t|t ]b p 0 or equivalently
s
p
b p 0 or equivalently
2s
b 2s

If the quality parameter t were common knowledge, then it would be socially optimal for
trade to happen no matter what the quality since for every t, tb > ts . However, when buyer
is uncertain about quality, trade happens only when b 2s . So the volume of transactions
drops in the presence of incomplete information.