The Market for lemons George Arkelof

1. READINGRESEARCHSEMINAR
FELLOWPROGRAMMEINRURAL
MANAGEMENT(FPRM)
TERM-V
THE MARKET FOR
“LEMONS”:
QUALITY UNCERTAINTY AND
THE MARKET MECHANISM
- GEORGE A. ARKELOF
PRESENTED BY:
ANUJ VIJAY BHATIA
FPRM 14 (2015)
INSTITUTE OF RURAL MANAGEMENT, ANAND
(IRMA)

2. ABOUT THE AUTHOR
• George Arthur Akerlof (born June 17, 1940) is an
American economist
• University Professor at the McCourt School of
Public Policy at Georgetown University and
• Koshland Professor of Economics Emeritus at
the University of California, Berkeley.
• In 2001 he was co-recipient of the Nobel Prize in
Economic Sciences, along with Michael Spence and
Joseph Stiglitz .
• The Nobel Committee cited Akerlof’s 1970 paper,
“The Market for ‘Lemons,’” which for the first time
described the role of asymmetric information in
causing market perversity.
• The paper has more than 26600 citations till date.
George Arthur
Akerlof
SCHOOL OF THOUGHT: CLASSICAL LIBERALISM

3.  This paper emphasizes on the problem of Market
Failure due to Information Asymmetry (and also
adverse selection and moral hazard).
 This paper also provides some solutions to counter
the problem of market failure due to information
asymmetry.
 Standard theories of competitive equilibrium usually
avoid this issues by assuming that all agents have
access to same information available free of cost.
PROBLEM

4.  Using the “Lemons” principle, this paper tries to show the
presence of information asymmetry in context of various
markets and the problem of adverse selection leading to
market failure. There is an incentive for pre-contract (ex-ante)
opportunism which induces adverse selection
THEORY
Information
Asymmetry
Adverse
Selection and
Moral hazard
Market
Failure

5.  Asymmetric Information:
Situation in which a buyer and a seller possess different
information about a transaction.
 Adverse Selection:
Form of market failure resulting when products of
different qualities are sold at a single price because of
asymmetric information, so that too much of the low-
quality product and too little of the high-quality product
are sold.
 Moral Hazard:
When a party whose actions are unobserved can affect
the probability or magnitude of a payment associated with
an event.
SOME BASIC CONCEPTS

6.  This is a theoretical/conceptual study.
 Uses cases of various markets – used car market,
insurance, labor markets, credit markets.
 Data: Secondary sources of data are used to support
theory. There is no primary data as well as no testing
procedures.
 Tools: Conceptual study
 No Empirical Base
 Could have merged with data analysis
METHODOLOGY

7.  Paper relates quality and uncertainty.
 Existence of goods of many grades – problem in
theory of markets.
 Quality differences and uncertainty may explain
labor market institutions.
 This paper also deals with Economic costs of
dishonesty, structure of money markets, notions of
insurability, liquidity of durables and brand-name on
goods.
THE MARKET FOR LEMONS
INTRODUCTION

8.  Buyers use statistic to judge the quality of
prospective purchases.
 Incentive of seller to market poor quality goods.
 As a result, the average quality of goods and the size
of market reduces.
 Social and private returns differ, Govt. intervention
may increase the welfare of all parties.
 Or private institutions may also arise to take
advantage of potential increase in welfare.
 But these institutions are nonatomistic and hence,
there can be concentration of power – with all ill
consequences.

9.  Example of used cars.
 q probability of good cars
 (1 – q) probability of bad cars
 Information asymmetry: Sellers know more than buyers –
Good cars and lemons sell at the same price
 Lemons will drive out the good cars.
THE MODEL WITH AUTOMOBILES
AS AN EXAMPLE
QUALITY: NEW OLD
GOOD q q
BAD (LEMONS) 1 – q 1 -- q

10.  In case of goods with continuous grades, even worst
pathologies can exist.
 Demand Qd = D (p, μ ), where p is price and μ is the
average quality of used car.
 Average quality μ = μ (p)
 Supply S = S(p)
 Equilibrium: S(p) = D (p, μ )
 If the price falls, so will the quality and goods will
not be traded at any price.
ASYMMETRICAL INFORMATION

11.  Suppose there are 2 groups of traders: Group1 and Group2
 Utility function of group 1:
 Income for Group1 traders be Y1 and for Group2 be Y2
 The demand for automobiles by Group1 traders will be:

12.  Similarly, demand for Group2:
 However, no trade with take place with price p and average
quality p/2 at any price level, in spite of the fact that at any
given price between 0 and 3, there are traders of group1 who
are willing to sell their automobiles at a price which traders of
Group2 are willing to pay.

13.  Suppose the quality of cars is uniformly distributed, 0≤ x ≤2.
 The demand and supply curves can be written as follows:
 If traders of both group have same probabilistic estimates
about the quality of individual automobiles, there will still be
equilibrium and p will then represent the expected price of
one quality unit.
SYMMETRIC INFORMATION
• If N < Y2, there is a gain in
utility over the case of
asymmetrical information of
N/2.
• If N > Y2, in this case income
of Group2 traders is
insufficient to buy all N
automobiles, there is a gain
in utility of Y2/2 units.

14.  When product quality is unobservable by buyers,
sellers will lower product quality.
 Buyers will expect sellers to “skimp” on quality, and
they lower their willingness to pay.
 Prices will decline.
 In turn, sellers will be forced to lower quality even
further to make profits at the lower prices.
 Thus, quality will decline until nothing but the lowest
quality lemons are left.
LEMONS MARKET SUMMED UP

15.  Consider the following statistics:
 Individuals have better information about their health
than the insurers.
 Only those with a greater than average risk will choose to
insure
 Under this scenario the insurer makes a loss.
EXAMPLES AND APPLICATIONS
A. INSURANCE
Age below 64 Age 65 and above
Insurance Coverage 63% 31%
Average Medical Expense $88 $77
Non-Insured Medical Expense $66 $80
Insured Medical Expense $105 $77

16.  Insurer can raise premium but this forces more
individuals not to insure
 Ultimately premiums are raised to the level where
no-one insures
 This is the adverse selection problem
 In practice individuals have different attitudes to risk
 Also many do not know precisely their own level of
risk.
 Group Insurance by Employers is a solution. But is it
all?

17.  Employers may refuse to higher minorities for certain
jobs
 Profit maximization – race may serve as a good statistic
for social background, quality of schooling, general job
capabilities
 Good quality schooling-Substitute
 Credibility of school must be good
 Rewards for work in slum schools accrue to the group,
not to individuals.
 Additional information apart from the information about
the race should be used and applicants shouldn’t be
judges as per the chracteristic of the group to which they
belong in order to incentivise for training.
EMPLOYMENT OF MINORITIES

18.  Dishonest dealings drive out good dealings out of the market.
 The cost of dishonesty = amount by which the buyer is
cheated + cost incurred by driving legitimate business out
Quality variation is more in underdeveloped markets
 For instance in India 85% of export goods is placed under QC
 Identifying the quality of goods is a challenging task and the
people who are adept at doing this are the successful
merchants.
 In production these skills are equally important to identify the
quality of inputs and to certify the quality of outputs.
 This is one of the reasons why the merchants may logically
become the first entrepreneurs.
 Still Entrepreneurship is scarce resource because, firstly pay -
off to trade is great for would be entrepreneurs and hence
they are diverted from production. Secondly, the amount of
entrepreneurial time per unit output is greater, the greater
the quality variations.
THE COSTS OF DISHONESTY

19.  In India, major fraction of industrial enterprise is
controlled by managing agencies.
 The managing agencies are dominated by castes. This
prevails because communal ties can be exploited to
ensure honest dealings.
 In the loan system operating in rural India, landlords
charge exorbitant interest rates to peasants because the
peasants wouldn’t be granted loans by banks and credit
unions because of lack of sound credit history and
credibility.
 Landlords being an integral part of the society can keep
a close eye on the borrower and tend to enforce their
contracts via easy means.
CREDIT MARKETS IN UNDERDEVELOPED
COUNTRIES

20. Institutions that counteract the effects of quality
uncertainty
 Guarantees
 Brand-names
 Chains (hotels, restaurants)
 Licenses (meaning professional licensing of doctors,
lawyers, barbers, Ph.D., Nobel Prize)
 Education and Labor markets themselves have their
own “brand names”.
COUNTERACTING INSTITUTIONS

21.  Trust is important.
 Informal unwritten guarantees are precondition for trade
and production.
 Where these guarantees are indefinite – business will
suffer.
 Difficulty of distinguishing good quality from bad is
inherent in the business world.
 This may explain many economic institutions and may be
one of the more important aspects of uncertainty.
CONCLUSION

22.  Knowledge is Power – Francis Bacon
 Information is tremendously required in Economic Interactions.
 Information Asymmetry provides an explanation to many
economic institutions.
 Stock Markets
 Commodity markets
 Insurance, Microfinance
 Employment and labor markets
 Development Economics
 New Field of Information Economics
 This can be applied to theories in industrial organization and
microeconomic dynamics, efficiency wage theories of
unemployment, credit market rationing theory, and issues of
economic development and global stability.
IMPLICATIONS AND IMPORTANCE OF
STUDY

23.  Information is a public good.
 But information is asymmetric.
 Access to information and transparency is the key to
reduce the pathologies of Moral Hazard and Adverse
Selection.
 Strengths
 Explain previously unexplained economic phenomena.
 Explain counteracting market institutions.
 Information is used as a market determinant.
 Can be applied to other disciplines – used to analyze the
effect of forgeries on the market of art paintings and to
study the model of propagation of the HIV.
IMPLICATIONS AND IMPORTANCE OF
STUDY

24.  Spence states in his 1976 paper that "[in some cases] There
will be random variation in signaling costs that prevent the
employer from distinguishing perfectly among individuals of
varying productive capabilities.“
 The applications of the theory also only consider asymmetries
in one direction. It may, however, be that there are also
information differences in the favor of the other party.
 The theory itself might be faulty in its simplistic assumptions.
For example,
 The theory assumes that the buyers always know the average
value of the items on sale. This kind of information may not
always be available, typically in the case of unique market
items. Although there will probably still be an asymmetry of
information in these cases.
LIMITATIONS AND CRITICISM

25. 1. Akerlof, G. A. (1970). The market for" lemons": Quality
uncertainty and the market mechanism. The quarterly
journal of economics, 488-500.
2. Auronen, L. (2003, May). Asymmetric information: theory
and applications. In Seminar of Strategy and International
Business as Helsinki University of Technology.
REFERENCES