A market for Lemons

A Market for Lemons

• Charles A. Holt

• Roger Sherman

Market Failure Under Asymmetric Information

• 1970, George Akerlof, publishes

• The Market for "Lemons": Quality Uncertainty and the Market Mechanism

• The Quarterly Journal of Economics,

• Vol. 84, No. 3. (Aug., 1970)

Akerlof’s Lemons

• When product quality is unobservable by buyers, sellers will lower product quality.

• Buyers will expect sellers to “skimp” on quality, and they lower their willingness to pay.

• Prices will decline.

• In turn, sellers will be forced to lower quality even further to make profits at the lower prices.

• Thus, quality will decline until nothing but the lowest quality lemons are left.

Akerlof’s Lemons

• Thus, the market fails!

• Sellers cannot sell high quality goods at high prices even though buyers would be willing to pay the high prices for the high quality goods!

The Model (in brief)

• An object has value

• This value is known a priori to the seller.

• A buyer does not know ,

• but does know that

• The buyer finds out the true value of v only after he has purchased the object.

• (and, then it’s too late! No refunds!)

The Model (in brief)

• The seller’s utility is:

• The buyer’s utility is:

• With

• So trading is always Pareto-optimal.

The Model (in brief)

• The seller sells if:

• Thus, by selling the object, he signals:

The Model (in brief)

• The buyer buys if:

• And, he knows that

The Model (in brief)

• So, the buyer buys if:

• and,

• So,

The Model (in brief)

• Thus, trade occurs only if

• Having is not enough.

• If but , the market FAILS.

The Classroom Experiment

Let’s Look at Our Results

Hold and Sherman’s Results