In this article, the author examines the relationship between quality and uncertainty and their implication on the theory of markets. Akerlof uses the example of the automobile market in order to illustrate the effects of uncertainty and quality on consumer behavior. In his example, Akerlof begins with the assumption that consumers have the option of either buying a new or used car.
However, the consumer cannot predict whether the car that they buy is a good car or a “lemon”. Therefore, the probability of a car being good can have a probability of q while the probability of a lemon would be (1-q). This probability increases, however, as time progresses and you learn about your car. Therefore, it can be seen that the seller will have a more accurate prediction on the quality of the car as opposed to the buyer because the seller has more information on the car.
The problem is that the seller is forced to sell his car at a price which disregards quality because buyers are unable to tell the difference between a good car and a lemon. Therefore, the seller is not able to receive the true value of his car and therefore forced to operate under a loss.
Akerlof continues this analogy in other examples. In the insurance industry, the elderly have problems obtaining insurance due to the drastic spike in premium cost. Research has shown that as the price level rises, the people who insure themselves will be those who are increasingly certain that they will need insurance. This means that as the average medical condition of the insurered deteriorates, the price level rises, with the result that no insurance sales may take place at any price.
Akerlof also uses the example of employing minorities, the cost of dishonesty, and the credit markets in underdeveloped countries to make his point. He has shown how “trust” is extremely important in any business transaction. Informal guarantees are preconditions for trade and business.