This is “Market for Lemons”, section 18.1 from the book Beginning Economic Analysis (v. 1.0).
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Nobel laureate George Akerlof (1940– ) examined the market for used cars and considered a situation known as the market for lemonsA model where sellers are better informed about quality than buyers., where the sellers are better informed than the buyers. This is quite reasonable because sellers have owned the car for a while and are likely to know its quirks and potential problems. Akerlof showed that this differential information may cause the used car market to collapse; that is, the information possessed by sellers of used cars destroys the market and the opportunities for profitable exchange.
To understand Akerlof’s insight, suppose that the quality of used cars lies on a 0 to 1 scale and that the population of used cars is uniformly distributed on the interval from 0 to 1. In addition, let that quality represent the value a seller places on the car, and suppose buyers put a value that is 50% higher than the seller. Finally, the seller knows the actual quality, while the buyer does not.
Can a buyer and seller trade in such a situation? First, note that trade is a good thing because the buyer values the car more than the seller. That is, both the buyer and seller know that they should trade. But can they agree on a price? Consider a price p. At this price, any seller who values the car less than p will be willing to trade. But because of our uniform distribution assumption, this means the distribution of qualities of cars offered for trade at price p will be uniform on the interval 0 to p. Consequently, the average quality of these cars will be ½ p, and the buyer values these cars 50% more, which yields ¾ p. Thus, the buyer is not willing to pay the price p for the average car offered at price p.
The effect of the informed seller and uninformed buyer produces a “lemons” problem. At any given price, all the lemons and only a few of the good cars are offered, and the buyer—not knowing the quality of the car—isn’t willing to pay as much as the actual value of a high-value car offered for sale. This causes the market to collapse; and only the worthless cars trade at a price around zero. Economists call this situation, where some parties have information that others do not, an informational asymmetrySituation in which some parties have information that others do not..
In the real world, of course, the market has found partial or imperfect solutions to the lemons problem identified by Akerlof. First, buyers can become informed and regularly hire their own mechanic to inspect a car they are considering. Inspections reduce the informational asymmetry but are costly in their own right. Second, intermediaries offer warranties and certification to mitigate the lemons problem. The existence of both of these solutions, which involve costs in their own right, is itself evidence that the lemons problem is a real and significant problem, even though competitive markets find ways to ameliorate the problems.
An important example of the lemons problem is the inventor who creates an idea that is difficult or impossible to patent. Consider an innovation that would reduce the cost of manufacturing computers. The inventor would like to sell it to a computer company, but she or he can’t tell the computer company what the innovation entails prior to price negotiations because then the computer company could just copy the innovation. Similarly, the computer company can’t possibly offer a price for the innovation in advance of knowing what the innovation is. As a result, such innovations usually require the inventor to enter the computer manufacturing business, rather than selling to an existing manufacturer, entailing many otherwise unnecessary costs.