Monday, March 22, 2010

“The market for Lemons”

"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper by the economist George Akerlof. It discusses information asymmetry, which occurs when the seller knows more about a product than the buyer. Akerlof, Micheal Spence, and Joseph Stiglitz jointly received the Nobel Memorial Prize in Economic Sciences in 2001 for their research related to asymmetric information. Akerlof's paper uses the market for used cars as an example of the problem of quality uncertainty. There are good used cars and defective used cars ("lemons"), but because of asymmetric information about the car (the seller knows much more about the problems of the car than the buyer), the buyer of a car does not know beforehand whether it is a good car or a lemon. So the buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of a car of known average quality. This means that the owner of a good used car will be unable to get a high enough price to make selling that car worthwhile.

Therefore, owners of good cars will not place their cars on the used car market. This is sometimes summarized as "the bad driving out the good" in the market. "Lemon market" effects have also been noted in other markets, such as used computers and the online dating "market". There are also parallels in the insurance market, where, unless a mandate for insurance is in place, it is those most likely to need insurance compensation (i.e., those most likely to get in accidents) who tend most to buy insurance, eliminating the advantage of diffusing risk that insurance is supposed to provide adverse selection.