A Market for Lemons

Charles A. HoltRoger 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!)

[0,1]v

v~ [0,1]v U

The Model (in brief) The seller’s utility is:

The buyer’s utility is:

With So trading is always Pareto-optimal.

s su p v

b bu v p

b s

The Model (in brief) The seller sells if:

Thus, by selling the object, he signals:

0s su p v

sv p

s

pv

The Model (in brief) The buyer buys if:

And, he knows that

and ~ [0,1]s

pv v U

0b b bE u E v p E v p

bE v p

The Model (in brief) So, the buyer buys if:

and,

So,

|bE v p p

|2b b

s

pE v p p p

|2 s

pE v p

The Model (in brief) Thus, trade occurs only if

Having is not enough.

If but , the market FAILS.

2b s

b s

b s 2b s

The Classroom Experiment

Quality Grade 1

Quality Grade 2

Quality Grade 3

The Best

Let’s Look at Our Results

Hold and Sherman’s Results

Complete Market Failure