The Market for “Lemons”: Quality Uncertainty and the Market Mechanism discusses the problems and effects of asymmetric information within a market. Asymmetric information occurs when a seller knows more about the product than the buyer. When the seller withholds important information from the buyer, such as if the good is in proper working order, it creates dishonesty in the market, which drives honest sellers and buyers away. Akerlof understands that the cost of dishonesty can be detrimental as it may cause the market to collapse entirely.
Akerlof uses the market for new and used cars as an example to show the problem of uncertainty. When buying a used car, you are faced with two types of cars; a car in good working order or a ‘lemon’. A ‘lemon’ is a slang term used to describe a car that is found to be defective after purchase. Due to the fact the consumers of used cars are unable to tell whether the car is in working order or a “lemon”, they run a risk of buying a faulty car.
The uncertainty within the buyer means that they will not be willing to pay market price for fear of the car being a ‘lemon’. But what the buyer does know is that ‘with probability q it is a good car and with probability (1-q) it is a lemon; by assumption, q is the proportion of good cars produced and (1-q) is the proportion of lemons’.1 (Akerlof, 1970) Bad cars drive out the good cars due to the fact that the good cars are sold at the same price as the lemons.
The market becomes saturated with lemons, replacing higher quality cars resulting in the collapse of the market. In essence, the bad money drives out the good. This significant gap in knowledge now results in adverse effects for the markets; buyers are unwilling to pay market price for a car and sellers will be unable to receive a fair price for their goods. Market values fall as good quality cars are less likely to sell due to the fact that the market is saturated with lemons. This, in turn, results in no market existing at all.
Akerlof uses the term ‘adverse selection’ to explain the result of asymmetrical information with regards to over 65’s obtaining health insurance. He questions why the price of insurance does not rise to match the risk. This is due to the fact that those who are most likely to insure themselves are those most likely to need medical assistance. ‘The result is that the average medical condition of insurance applicants deteriorates as the price level rises- with the result that no insurance sales may take place at any price’.2 (Akerlof, 1970) We can compare the market for insurance with the market for used cars as the average quality of used cars supplied to the market fell as the price falls. In a 1956 national sample survey, Akerlof notes how insurance coverage drops for people aged between fifty five and sixty four from sixty three per cent to thirty one per cent for those aged over sixty five. It can be concluded that insurance companies are hesitant to insure those over the age of sixty five. Insurance prices rise as asymmetrical information becomes more prominent in the acquisition of health insurance. This may be due to fraud, exaggerated claims or the with-holding of important information. Group insurance may be made available, for healthy clients. This means that insurance is not available for those who need it most. Companies are making their own ‘adverse selection’.
The market for lemons can also apply to the employment of minorities. When a buyer, or on the case an employer, has pre conceived ideas about a particular minority, they may act in a discriminatory way. According to Akerlof, ‘this decision may not reflect irrationality or prejudice -but profit maximization’. The author believes that race may serve as a statistic for which to judge an applicant’s upbringing and background. However, Akerlof believes that, through educational certificates, minority groups can be better graded as to their level of potential talent. Akerlof (1970) notes that ‘an untrained worker may have valuable natural talents, but these talents must be certified by “the educational establishment” before a company can afford to use them’.3 Those minorities who are already at a disadvantage may be further subject to discrimination as it is difficult for an employer to distinguish between ‘those with good job qualifications from those with bad qualifications’.
Work in slum areas can help to remove the stigma attached to minorities groups. This aims to remove the stigma attached to the group as a whole, rather than the individual. However, the office of economic opportunity will, in order to examine the benefits and gains of its programmes, implement a cost- benefit analysis. Many of the benefits gain by minorities may be external. The benefit from training minority groups may accrue to the group as a whole, rather than one certain individual. Simply put, many, but not all individuals will benefit from such programmes. Likewise, the benefit of the programme may accrue to an individual rather than the entire group. It is concluded, however, that work in slum schools raises the average quality of the group.
George Borjas notes, on the contrary, that often time’s racial prejudice is based on a preference for discrimination rather than profit maximisation. He argues that discrimination does not pay. For example, the decision to hire only white workers and no minority workers can be shown as unprofitable in two distinct ways. Firstly, in order to attract a greater pool of white workers, the employer must raise the wage rate. Because minority workers and white workers are perfect substitutes for each other, the non-discriminating firm can produce the same amount of output at a lower price. Secondly, firms that only hire white workers, according to Borjas, hire the wrong amount of workers whereas a non- discriminatory firm would hire more workers. Borjas (2008) concludes that’ the most profitable firm is the firm that has a zero discrimination coefficient’.
Dishonesty has a deeply negative impact on markets. As customers may not always be in a position to tell whether the good is of genuine or poor quality, they risk buying goods where the characteristics may be misrepresented. A market that contains both potential buyers and sellers of good quality goods are driven out of the market by the presence of those who wish to sell illegitimately. ‘The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence’.5 (Akerlof, 1970) Dishonesty is a serious issue in economic trade in underdeveloped countries. The need of quality control of exports is one indicator of the problem in India. Akerlof (1970) writes that ‘Indian housewives must carefully glean the rice of the local bazaar to sort out stones of the same colour and shape which have been intentionally added to the rice’.6 Those who are willing to sell dishonestly can cause the market to be driven out of existence as people will become unwilling to pay for a good where the quality is not genuine. Akerlof explains that if a merchant has the important skill of being able to decipher between a quality product and a fake imitation, these merchants may logically become the first entrepreneurs.
Credit markets in underdeveloped countries are often unable to flourish due to dishonestly. Firms that establish a reputation for honest dealings often results in a monopoly rent and therefore higher charges which many individuals would struggle to pay back. Similarly, often times the sources of finance are limited to local communal groups to encourage honest dealing within the community. Akerlof acknowledges that it is ‘extraordinarily difficult to discern whether the savings of rich landlords failed to be invested in the industrial sector (1) because of a fear to invest in ventures controlled by other communities, (2) because of inflated propensities to consume, or (3) because of low rates of return’.7 (Akerlof, 1970)
Various institutions have arisen in order to protect the market against uncertainty. Many goods and services today carry ‘guarantees’ in order to insure the buyer of quality. When a guarantee is offered, the risk of purchasing faulty goods is borne by the seller rather than the buyer. Another example of a measure to insure quality are brand named goods. Brand names both insure the quality of the good is genuine and allows for retaliation if the brand name does not meet expectations. Chains also offer similar measures to ensure quality as brand names. A consumer will trust a chain as they can be assured of the quality of the product. For example, a McDonalds along an inter-urban highway in the States will have very few regular customers. Many people will still eat at the restaurant as they can be assured of the quality of the burger and know what they will be getting. Licensing practices such as doctors or lawyers also help to ensure quality within the market. Most skilled labour carries some certification indicating the attainment of certain levels of proficiency.
Akerlof’s article, however, has been criticised on several different grounds. Many economic journals refused to publish the article of the grounds of its triviality. High quality journals such as the American Economic Review, the Review of Economic Studies and the Journal of Political Economy all refused his paper citing it was ‘trivial’ and that his findings were incorrect. Akerlof (2001) writes ‘I sent “Lemons” to the Journal of Political Economy, which sent me two referee reports, carefully argued as to why I was incorrect’.8 The referee reports concluded that ‘if this paper was correct, economics would be different’.9 (Akerlof, 2001) In his paper, Akerlof also disregards the fact that consumers can seek ways in order to ensure that the car they are about to purchase is not a lemon. Similarly, rather than tarnish their reputation, used car sellers may offer a guarantee on their car for a certain length of time so as to allow the buyer to come to the conclusion whether it is a quality car or a lemon.
Dishonesty can have a deeply negative effect on a market. When buyers and sellers are not equally informed about the quality of goods and services asymmetrical information is created. As I have discussed there are a variety of markets and other factors threatened by asymmetrical information. Being able to distinguish the between the quality of goods and services in the business world is an important trait as it may be the only factor protecting a market. Guarantees can protect a market from collapse, but as Akerlof (1970) concludes, ‘where these guarantees are indefinite, business will suffer’.10