The Market for Lemons
Conor Callaghan
10326211
The Market for "Lemons": Quality Uncertainty and the Market Mechanism
George A. Akerlof
The Market for "Lemons": Quality Uncertainty and the Market Mechanism discusses the problems and effects of asymmetric information within a market. Asymmetric information occurs when a seller knows more about the product than the buyer. When the seller withholds important information from the buyer, such as if the good is in proper working order, it creates dishonesty in the market, which drives honest sellers and buyers away. Akerlof understands that the cost of dishonesty can be detrimental as it may cause the market to collapse entirely.
Akerlof uses the market for new and used cars as an example to show the problem of uncertainty. When buying a used car, you are faced with two types of cars; a car in good working order or a ‘lemon’. A ‘lemon’ is a slang term used to describe a car that is found to be defective after purchase. Due to the fact the consumers of used cars are unable to tell whether the car is in working order or a “lemon”, they run a risk of buying a faulty car. The uncertainty within the buyer means that they will not be willing to pay market price for fear of the car being a ‘lemon’. But what the buyer does know is that ‘with probability q it is a good car and with probability (1-q) it is a lemon; by assumption, q is the proportion of good cars produced and (1-q) is the proportion of lemons’.1 (Akerlof, 1970) Bad cars drive out the good cars due to the fact that the good cars are sold at the same price as the lemons. The market becomes saturated with lemons, replacing higher quality cars resulting in the collapse of the market. In essence, the bad money drives out the good. This significant gap in knowledge now results in adverse effects for the markets; buyers are unwilling to pay market price for a car and sellers will be unable to receive a fair price for their goods. Market values fall as good quality cars are less
10326211
The Market for "Lemons": Quality Uncertainty and the Market Mechanism
George A. Akerlof
The Market for "Lemons": Quality Uncertainty and the Market Mechanism discusses the problems and effects of asymmetric information within a market. Asymmetric information occurs when a seller knows more about the product than the buyer. When the seller withholds important information from the buyer, such as if the good is in proper working order, it creates dishonesty in the market, which drives honest sellers and buyers away. Akerlof understands that the cost of dishonesty can be detrimental as it may cause the market to collapse entirely.
Akerlof uses the market for new and used cars as an example to show the problem of uncertainty. When buying a used car, you are faced with two types of cars; a car in good working order or a ‘lemon’. A ‘lemon’ is a slang term used to describe a car that is found to be defective after purchase. Due to the fact the consumers of used cars are unable to tell whether the car is in working order or a “lemon”, they run a risk of buying a faulty car. The uncertainty within the buyer means that they will not be willing to pay market price for fear of the car being a ‘lemon’. But what the buyer does know is that ‘with probability q it is a good car and with probability (1-q) it is a lemon; by assumption, q is the proportion of good cars produced and (1-q) is the proportion of lemons’.1 (Akerlof, 1970) Bad cars drive out the good cars due to the fact that the good cars are sold at the same price as the lemons. The market becomes saturated with lemons, replacing higher quality cars resulting in the collapse of the market. In essence, the bad money drives out the good. This significant gap in knowledge now results in adverse effects for the markets; buyers are unwilling to pay market price for a car and sellers will be unable to receive a fair price for their goods. Market values fall as good quality cars are less
Bibliography: 1Akerlof, G. (1970) The Market for "Lemons": Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84, (3): 489. 2 Akerlof, G. (1970) The Market for "Lemons": Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84, (3): 492-493. 3 Akerlof, G. (1970) The Market for "Lemons": Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84, (3): 494. 4 Borjas, G. (2008) Labor Economics. 4th Edition. New York: Mc Graw- Hill. 5 Akerlof, G. (1970) The Market for "Lemons": Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84, (3): 495. 6 Akerlof, G. (1970) The Market for "Lemons": Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84, (3): 496. 7 Akerlof, G. (1970) The Market for "Lemons": Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84, (3): 498. 8Akerlof, G. (2001) Writing the "The Market for 'Lemons '": A Personal and Interpretive Essay. Available at: http://www.nobelprize.org/nobel_prizes/economics/laureates/2001/akerlof-article.html. [Accessed 26 September 2012] 9 Akerlof, G. (2001) Writing the "The Market for 'Lemons '": A Personal and Interpretive Essay. Available at: http://www.nobelprize.org/nobel_prizes/economics/laureates/2001/akerlof-article.html. [Accessed 26 September 2012] 10 Akerlof, G. (1970) The Market for "Lemons": Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84, (3): 500.