The Market for "Lemons": Quality Uncertainty and the Market Mechanism by George A. Akerlof is a marvellous addition to economic literature. The theory outlined by Akerlof explains how asymmetric information can cause market failure. The most remembered part of the paper is the discussion about the second-hand motor vehicle market. The paper also considers how asymmetric information affects insurance and employment of minority races. In my opinion, the motor vehicle example is the most interesting and the most relatable of all the examples given in the paper
Akerlof used the example of the second-hand motor vehicle market as it was considered an easy example to demonstrate the effect asymmetric information has on markets. The price of second-hand motor vehicles are considerably lower than the price of new motor vehicles. Even if a motor vehicle is only a year old, the price is likely to be more 15% lower than the new version; see car4cash and ominicalculator to gain an appreciation for the significant fall in second-hand car prices. Akerlof attempts to explain this significant drop in price with his ‘Lemons’ theory.
Lemons Theory explained in the context of motor vehicles
To begin, I would like to clarify the terminology used. A ‘lemon’ is used to describe a motor vehicle that is low quality. A ‘peach’ is used to describe a motor vehicle that is high quality. Akerlof does not use the terminology ‘peaches’ in the paper. I am not sure when it was introduced but I will refer to high quality motor vehicles as peaches in this post.
The seller has far more information about the motor vehicle than the buyer does. This is what is considered as asymmetric information. The buyer has different willingness-to-pay for motor vehicles of different quality. For example, the buyer might be willing to pay $2,000 for a lemon and $4,000 for a peach. If the buyer estimates that half the motor vehicles sold are lemons and half are peaches. In theory, the buyer would be willing to pay $3,000 (0.5 × 2,000 + 0.5 × 4,000 = 3,000). This is a great price for someone selling a lemon but a terrible price for someone selling a peach. There is far greater incentive to sell lemons than peaches. Therefore, the number of lemons sold increases. However, buyers will adjust their expectations and prices will fall further. For example, if 90% of second-hand motor vehicles were lemons, the price would fall to $2,200 (0.9 × 2,000 + 0.1 × 4,000 = 2,200). The lower price would further disincentivise the sale of peaches. This could eventually result in market failure for peaches. In other words, there would be no second-hand peaches sold.
Does the logic work?
The general idea makes sense. If buyers cannot distinguish between low and high quality goods, they will lower their willingness-to-pay to account for risk. Sellers with the low quality goods will be able to sell at or above their desired selling price. While sellers with high quality goods will either not sell at all or sell below their desired selling price.
In the case for motor vehicle markets, it is unlikely that there will be complete market failure for high quality second-hand motor vehicles. Firstly, people with well-maintained (high quality) motor vehicles will eventually want a different motor vehicle or find they no longer need the motor vehicle. Secondly, even though potential buyers of a motor vehicle do not have perfect information about a motor vehicle, there are still some indicators of the quality of a motor vehicle. These indicators include the motor vehicle service log book, the mileage, the reputation of the motor vehicle model of that year, owner membership in motor vehicle clubs, the physical appearance of the motor vehicle, and inspection from a trained mechanic.
As explained above, Akerlof’s lemons theory is not likely to result in market failure for ‘peach’ motor vehicles but certainly offers a contributing factor for the lower prices of second-hand motor vehicles. Other factors could also include the positive feeling attached to owning something new, the advantage of being able to customise and select the colour of the motor vehicle, and better options for financing the motor vehicle.
Is Akerlof’s lemons theory still relevant today?
Akerlof wrote his paper The Market for "Lemons": Quality Uncertainty and the Market Mechanism in 1970. Even though the world is quite a difference place than it was 50 years ago. I believe his theory is still relevant today. It is still relevant to employment as well as the sale of insurance as discussed in his paper. The theory can be applied whenever there is an opportunity to exploit asymmetric information. For example journalism. The audience does not immediately know the quality of information released by the media. This creates the opportunity to release inaccurate or sensationalised information. However, its reliability becomes more apparent over time. This has reduced the confidence people have in the information presented by the media (mainstream). This is likely to be one of the reasons alternative media has become very popular. However, alternative media also suffers from reliability issues for similar reasons. This does not mean that the market for quality journalism is dead but it is less incentivised than it should be. There are journalists that care more about the integrity of their work than money but they might be in the minority.
The ‘lemons’ theory is likely to be even more applicable for one off transactions, as maintaining a good reputation is not required as there will not be future transactions. Eventually finding out something is low quality does not hurt the seller, as the seller will not be selling that item to the same buyer again. This is often the case when selling a second-hand item, which is relevant to Akerlof’s motor vehicle example. The ‘lemons’ theory could also be applied to running for office for a single term. There is incentive to make promises without the fear of not being re-elected for not fulfilling them. Another example would be selling a business. The business owner will only sell his or her business once. If the business does not live up to the buyers expectations, the business seller does not have to worry about loss of future transactions.
How to avoid the problems demonstrated by the lemons theory
Most of the problems discussed relate to asymmetric information. The sellers with the higher quality products tend to be biggest losers. The buyers lose out by reduced access to higher quality products but the lower prices from previous observed lower quality products mitigates some of that loss. The sellers of low quality products initially gain by selling lower quality products at a higher price but a poor track record erodes that profit as prices fall.
Sellers of high quality products should aim to reduce the extent of asymmetric information. They should provide evidence that their product is high quality. In regards to motor vehicles. The seller can provide evidence of maintenance and frequent servicing. If the seller has sold items previously, he or she can provide evidence of quality through ratings and previous feedback. This is can be done by selling products online. Websites such as Amazon and eBay display reviews and ratings of products. For one off selling, it is more difficult to demonstrate quality. For example selling a business. The seller needs to demonstrate the viability of the business, the record of accomplishment, and provide reason for why they can no longer run the business themselves.
The Akerlof’s ‘lemon’ theory provides a few interesting insights regarding the effect of asymmetric information on markets. Asymmetric information adds risk to the buyer and therefore lowers prices. This hurts sellers of higher quality products but benefits sellers of lower quality products. This could potentially lead to market failure as all sellers of high quality products may no longer sell. I believe total market failure is very unlikely as sellers of high quality products will sometimes need to sell even at a lower price than what they desire. In the case of motor vehicles, a person with a well-maintained motor vehicle may strongly desire a new motor vehicle or could be moving overseas and would therefore be willing to accept a lower price.
The Akerlof’s ‘lemon’ theory is most applicable to one off sales. This is because the seller does not need to maintain a good reputation. This is a key point that makes the second-hand motor vehicle market a good example.
Both sellers of high quality products and buyers that desire high quality products would want to reduce the level of asymmetric information. Sellers can do that by offering as much information as possible about the quality of their product. When possible, they could also provide information regarding past performance and quality. Buyers can access information online or request more information from sellers.
Previous posts relating to market failure
I have discussed market failure in my post ’How do we prevent market failure caused by over delegation of Steem Power to bid-bots?’. If you are interested in how Steem might experience market failure for higher quality posts, I suggest you give this post a read.
If you want to read any of my other posts, you can click on the links below. These links will lead you to posts containing my collection of works. These posts will be updated frequently.
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