Market for lemons

A market for lemons is one in which consumers cannot distinguish products of quality from defective goods. In such a market, consumers assume they will be sold a product of the lowest quality and so become unwilling to pay a price higher than they would for such a ‘lemon.’ As a result, it becomes economical to produce only products of the lowest quality.

Nobel laureate George Akerlof examined the market for used cars and considered a situation where the sellers are better informed than the buyers. This is quite reasonable, as 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.

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.

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 the differential information an informational asymmetry.

Akerlof’s 1970 essay, “The Market for Lemons”, has been described as “the single most important study in the economics of information.” In it, Akerlof offers the revolutionary idea that when agents on one side of a transaction are better informed, some markets may entirely fail to emerge.

Examples

The “all you can eat” buffet is a nice example. Because restaurants offering such buffets are unsure as to which patrons will eat a lot or a little, they must charge a price large enough to cover the average amount of food consumed. For customers with modest appetites, this price will be too high and only the customers with larger appetites will be willing to pay. However, since the average amount of food consumed by this group is even larger, the restaurants must charge an even higher price for their buffets. The relatively modest eaters for this group will leave and the price will go even higher. Eventually, only the hungriest, most insatiable diners will be left, a population not large enough to sustain the restaurants. The information asymmetry here is that customers have more knowledge about their own appetites than the restaurants do. The fix is to charge each customer for the amount he consumes, and this is probably why all-you-can-eat is the exception in commercial dining.