Nobel for Lemons
NOBEL FOR LEMONS * Priya Saxena
George A. Akerlof received the Sveriges Riksbank Prize in Economic Sciences in 2001 along with Michael Spence and Joseph Stiglitz for his celebrated work 'The Market for Lemons ' (1971) which talks about the implications of the asymmetrical information in the markets where uncertainty is involved. 'Market for Lemons ' was written during the time when the then prevailing economic theories were undergoing certain transitions. It was a result of an attempt to divert from the existing model of perfect competition with perfect information with all the parties. It discusses the problems posed by markets with goods of various ‘grades’ and how the uncertainty regarding the quality, arising out of information asymmetry, leads to market failure. In a market where the buyers make purchases on the basis of some market statistic, there arises the incentive for seller to market poor quality goods as the benefits associated with the sale of quality goods will accrue to the entire group of sellers constituting the market rather than to the individual seller offering the higher quality good alone. As a result there tends to be a reduction in the average quality of goods, and then to a market failure where sales of the relevant good will not take place regardless of the price.
Akerlof uses the example of car market to illustrate the problem. In the car market, there are both new and used cars, good cars and lemons (bad cars), and a new and used car can be either a good car or a lemon. In both the new and used car markets, a buyer will not know the exact quality of the car he is purchasing thus facing the possibility that the car he is about to purchase is either a quality car, notated by Akerlof as q, or a lemon, notated as 1—q. However, due to inadequate information, his valuation of each car, regardless of its actual quality, is based on the initial q / 1—q probability. The buyer will subsequently gain knowledge regarding the actual
George A. Akerlof received the Sveriges Riksbank Prize in Economic Sciences in 2001 along with Michael Spence and Joseph Stiglitz for his celebrated work 'The Market for Lemons ' (1971) which talks about the implications of the asymmetrical information in the markets where uncertainty is involved. 'Market for Lemons ' was written during the time when the then prevailing economic theories were undergoing certain transitions. It was a result of an attempt to divert from the existing model of perfect competition with perfect information with all the parties. It discusses the problems posed by markets with goods of various ‘grades’ and how the uncertainty regarding the quality, arising out of information asymmetry, leads to market failure. In a market where the buyers make purchases on the basis of some market statistic, there arises the incentive for seller to market poor quality goods as the benefits associated with the sale of quality goods will accrue to the entire group of sellers constituting the market rather than to the individual seller offering the higher quality good alone. As a result there tends to be a reduction in the average quality of goods, and then to a market failure where sales of the relevant good will not take place regardless of the price.
Akerlof uses the example of car market to illustrate the problem. In the car market, there are both new and used cars, good cars and lemons (bad cars), and a new and used car can be either a good car or a lemon. In both the new and used car markets, a buyer will not know the exact quality of the car he is purchasing thus facing the possibility that the car he is about to purchase is either a quality car, notated by Akerlof as q, or a lemon, notated as 1—q. However, due to inadequate information, his valuation of each car, regardless of its actual quality, is based on the initial q / 1—q probability. The buyer will subsequently gain knowledge regarding the actual
References: * George A. Akerlof. "The Market for 'Lemons ': Qualitative Uncertainty and the Market Mechanism," Quarterly Journal of Economics, 89 (August 1970), 488-500 * Hayne E. Leland and David H. Pyle. “ Informational Asymmetries, Financial Structure, and Financial Intermediation”, The Journal of Finance, Vol. 32, No. 2, Papers and Proceedings of the Thirty-Fifth Annual Meeting of the American Finance Association, Atlantic City, New Jersey, September16-18, 1976 (May, 1977), pp. 371-387 * Patrick J. Glen. Law as Asymmetric Information: Theory, Application, and Results in the Context of Foreign Direct Investment in Real Estate, Georgetown Public Law and Legal Theory Research Paper No. 10-57, Georgetown Business, Economics and Regulatory Law Research Paper No. 10-14 * J. Barkley Rosser, A Nobel Prize for Asymmetric Information: The Economic Contributions of George Akerlof, Michael Spence, and Joseph Stiglitz, Review of Political Economy (01/2003) * George A. Akerlof, Writing the "The Market for 'Lemons '": A Personal and Interpretive Essay * www.wikipedia.org