Akerlof_19702

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The Market for Lemons:The Market for Lemons:

Quality Uncertainty and theQuality Uncertainty and the

Market MechanismMarket MechanismGeorge A. Akerlof, (1970). Quarterly

Journal of Economics, 8 (!)" 88#

$00Group 1:

Meredith, Barclay, Woo-je, &

Kumar
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IntroductionIntroduction

In many markets where buyers use amarket statistic to judge quality,there is an economic incentive orsellers to market !oor quality

!roducts, since economic returns orgood quality accrue mainly to thegrou! "and not to the individual#

$hus, there tends to be a reduction inaverage quality o goods and also areduction in the si%e o the market

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The ModelThe Model

kerlo "'()*# uses the automobiles market"s!eci+cally the used car market# or itsconcreteness and ease in understanding

n individuals new car may be good or itmay be a lemon "bad quality car#, theindividual does not know when initially!urchasing the new car

ter a length o time, the owner has a betterestimate o the quality o the car, based on+rst-hand e!erience with a !articular car

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The ModelThe Model

n asymmetry in available inormation has

develo!ed. the sellers have more inormationabout the quality o a car than the buyers

But good cars and bad cars must sell at the

same !rice / since it is im!ossible or a buyer totell the di0erence between a good car and alemon

$hus, an owner o a good car cannot receive itstrue economic value, and the owner is locked in

$he result. Most cars traded are 1lemons2,and good cars may not be traded at all3

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Greshams LawGreshams Law

kerlo "'()*# suggests that bad cars drive outlemons in much the same way that 1bad moneydrives out good money2

$his is a reerence to 4reshams 5aw

4resham "'6'(-'6)(#lightened or worn coins traded at same value as coinswith more !recious metal content

7recious metal content coins saved, 1bad2 coins let tobe traded

kerlo stresses a di0erence. bad cars sell atsame !rice as good cars because o asymmetricinormation, yet in 4reshams law !resumablybuyer and seller distinguish good rom bad

money

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Asymmetrical InformationAsymmetrical Information

ssume demand or used carsde!ends on 8 variables / !rice "!# andaverage quality o used cars (u):Q=D(p,u)

9u!!ly and average quality willde!end on !rice. u=u(p) and S=S(p)

:quilibrium. S(p) = D(p,u(p))

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9uch an eam!le can be derived romutility theory. ssume 8 grou!s otraders

4rou!' utility unction. U1=M + x

"M is consum!tion o other goods, is

quality o ith car#

4rou!8. U2=M + (3/2)x

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ssum!tions.

Both traders utility maimi%ers

4rou!' has ; cars with uniormlydistributed quality , *

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4rou!' income = >', 4rou!8s = >8

?emand by grou!' or ty!e' tradersD1 = Y1/pwhen u/p>1

D1 = when u/p!1

9u!!ly o0ered by ty!e' tradersS2=p"/2 p#2

With average quality

U=p/2

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?emand by grou!8 or ty!e8 traders

D2 = Y2/p when 3u/2>pD1 = when 3u/2!p

9u!!ly o0ered by ty!e8 tradersS2=

$hus, total demand is.D(p,u) = (Y2 + Y1)/p $% p!uD(p,u) = Y2/p $% u!p!3u/2D(p,u) = $% p>3u/2

@owever, average quality at !rice ! is !A8 andthereore at no !rice will trade take !lace $his is ins!ite o the act that at any given !rice between *and C there are ty!e' traders willing to sell at a !rice

ty!e8 traders are willing to !ay

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ymmetric Informationymmetric Informationssume quality o cars uniormly distributed, *

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!"am#le $: Insurance!"am#le $: Insurance

7eo!le over H6 have diGculty buying medicalinsurance. Why doesnt the !rice rise to match therisk

kerlos answer. s !rice rises those that insurethemselves are those that know they need it, andaverage medical condition o a!!licantsdeteriorates as !rice rises / no insurance is sold atany !rice

4rou! insurance. o0ered to em!loyees "!icks outhealthy#

rgument or medicare. any !rice o0ered willattract to many 1lemons2 "analogous argument to

!ublicly +nanced roads#

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!"am#le %: !m#loyment of Minorities!"am#le %: !m#loyment of Minorities

:m!loyers may reuse to higher minorities orcertain jobs

7ro+t maimi%ation / race may serve as a goodstatistic or social background, quality oschooling, general job ca!abilities

4ood quality schooling-9ubstitute

Jredibility o school must be good

ewards or work in slum schools accrue to the

grou!, not to individuals

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!"am#le &: 'osts of (ishonesty!"am#le &: 'osts of (ishonesty

?ishonest dealings tend to drivehonest dealings out o the market"same logic as beore. !resence o!eo!le willing to o0er inerior goodstends to drive market out o eistence#

Jost o dishonesty not just that!urchaser is cheated, but thatlegitimate business is driven out obusiness

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!"am#le ): 'redit Markets in Underde*elo#ed 'ountries!"am#le ): 'redit Markets in Underde*elo#ed 'ountries

Indian 1managing agencies2 aregenerally classi+ed by communalorigin

9ources o +nance are limited tolocal communal grou!s that can

use communal or amily ties toencourage honest dealing

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'ounteractin+ Institutions'ounteractin+ Institutions

Institutions that counteract thee0ects o quality uncertainty

4uaranteesBrand-names

Jhains "hotels, restaurants#

5icenses "meaning !roessionallicensing o doctors, lawyers,barbers, 7h,?, ;obel 7ri%e#

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'onclusions'onclusions

kerlo "'()*# !rovides a thoroughtreatment o the e0ects o asymmetricinormation on trading in markets "qualityo !roducts in market, si%e and eistence

o market#

$he last !art o the article !oints out someinstitutions that counteract the e0ects oasymmetric inormation / this relatesdirectly to some areas in strategicmanagement "ie choice o governance

orm, !rinci!al-agent !roblems#

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Akerlof_19702