The Market for “Lemons”:

Quality Uncertainty & the Market

Mechanism
Akerlof (QJE 1970)
Presented by: Jay Li
Feb. 2007
 The Idea
• This paper relates quality and uncertainty.

• Buyers have incentive to sell inferior

goods when the quality of goods is difficult
to identify.

• When the buyer is less informed about the

quality than the seller, adverse selection
may result.
 Adverse Selection
• The buyers, wary of being cheated by
lemons, have lower willingness to pay for
the goods than if they have full
information. Meanwhile, with a lower price
acceptable by the buyers, sellers of high
quality good opt to quit, with only lemons
left on the market, further shrinking the
trade.
 Market for Used Cars
• The owners of a used car usually has better
knowledge about the quality of the car than the
buyer.

• Because the buyer cannot tell the difference,

bad cars and good cars have to be sold at the
same price.

• Good car owners are locked in while lemons

stay on the market.
 Formalize
• Group 1 of traders have N cars with quality Xi ~
Uniform(0,2), income Y1 (including the proceeds
from selling cars) and utility function

• Group 2 of traders have no cars, income Y2, and

utility function

• M is numeraire with price set to 1.

 Formalize
• Both groups of traders are von Neumann-
Morgenstern utility maximizers.

• The market demand and supply consist of

demands and supplies from both groups.

• The quality can be thought of as the underlying

value of the car. The expected quality of the cars
traded is denoted by mu.
 Formalize
• Writing the utility in indirect form
n
V1 ( p, Y1 )  Y1  np   xi  Y1  np  nE ( xi )  Y1  np  n
i 1

3 n 3 3
V2 ( p, Y2 )  Y2  np   xi  Y2  np  nE ( xi )  Y2  np  n
2 i 1 2 2

• Utility maximization for group 1 gives

• Utility maximization for group 2 gives

 Formalize
• The total demand is thus
 Formalize
• Group 1 supplies

• Average quality

• Only the cars with quality no more than p will be

supplied, which have expected quality p/2. The
proportion of cars that have quality no more than p is
p/2, resulting in a total supply of pN/2.

• Group 2 supplies 0.
 Formalize
• With average quality being p/2, at no price
will any trade take place (D(p,u)=0 is the
only scenario possible).

• Lemons drive trade out entirely.

 Another Perspective
• In competitive equilibrium, to have positive
demand, P=E[3/2x | x<=p].

• Group one would like to sell only if x<=p.

• Group one is willing to buy a positive

amount if the price paid equals the
expected utility gain conditioning on group
one would like to sell.
 Another Perspective
3
• That is, p  E[ x | x  p]
2
3 p
  xf ( x | x  p)dx
2 0
3 p 1
  x dx
2 0 p
3
 p
4
• Equilibrium is achieved only when p=0 and thus
no trade takes price.
 If Information is Symmetric
• Both groups have the same valuation of
the cars.
 If Information is Symmetric

D=(Y1+Y2)/p

S=N=Y2

S=N=2/3Y2
D=Y2/p

0 1 3/2 p
 If Information is Symmetric
• Note there is a maximum utility gain of N/2
if the equilibrium is competitive (scenario
(3)).
• With asymmetric information, no trade
takes place, U1+U2=Y1+Y2.
• With symmetric information and
competitive equilibrium (p=1),
U1+U2=Y1+Y2+N/2.
 Real World
• Insurance
– People more than 65 years old can hardly buy
medical insurance even if they are willing to
pay a high price. Insurance companies know
that with a high price, only those that are
more likely to take advantage of the insurance
will buy the policy. So policies are rarely sold
on this particular market.
 Real World
• Cost of dishonesty
– The presence of people who sell inferior goods tends
to drive out the legitimate business. It is not only are
the consumers cheated but also moral and legal
concerns rise.
– Expertise to tell the true value of undistinguishable
goods is easily directed to arbitrage rather than real
production purpose because the former is more
profitable in a world full of lemons.
 Real World
• Credit market in underdeveloped countries
– Entrepreneurs have to turn to “managing agencies”,
people and companies with reputation and communal
influence, for financing a newly started firm.
– Rural credit market is dominated by loans with
extortionate rates from local moneylenders rather
than those with official rates from formal banks since
only the former have good access to borrower’s
information. Anyone who try to arbitrage tends to
lose.
 Real World
• Counteracting institutions
– Warrantees for durable goods
– Brand-name goods and chains
– Licensing practices
– All aim to reduce information asymmetry