NOBEL ECONOMICS PRIZE WINNER 2001---GEORGE AKERLOF-MARKET FOR "LEMONS": AND MARKET MECHANISM

The example of used cars captures the essence of the problem. From time to time one hears either mention of or surprise at the large price difference between new cars and those which have just left the showroom. The usual lunch table justification for this phenomenon is the pure joy of owning a "new" car. We offer a different explanation. Suppose (for the sake of clarity rather than reality) that there are just four kinds of cars. There are new cars and used cars. There are good cars and bad cars (which in America are known as "lemons"). A new car may be a good car or a lemon, and of course the same is true of used cars. The individuals in this market buy a new automobile without knowing whether the car they buy will be good or a lemon. But they do know that with probability q it is a good car and with probability (1-9) it is a lemon; by assumption, q is the proportion of good cars produced and (1-q) is the proportion of lemons.

After owning a specific car, however, for a length of time, the car owner can form a good idea of the quality of this machine; i.e., the owner assigns a new probability to the event that his car is a lemon. This estimate is more accurate than the original estimate. An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers. But good can and bad cars must still sell at the same price- since it is impossible for a buyer to tell the difference between a good car and a bad car. It is apparent that a used car cannot have the same valuation as a new car -if it did have the same valuation, it would clearly be advantageous to trade a lemon at the price of new car, and buy another new car, at a higher probability q of being good and a lower probability of being bad. Thus the owner of a good machine must be locked in. Not only is it true that he cannot receive the true value of his car, but he cannot even obtain the expected value of a new car.

  Asymmetrical Information It has been seen that the good cars may be driven out of the market by the lemons. But in a more continuous case with different grades of goods, even worse pathologies can exist. For it is quite possible to have the bad driving out the not-so-bad driving out the medium driving out the not-so-good driving out the good in such a sequence of events that no market exists at all. One can assume that the demand for used automobiles depends most strongly upon two variables -the price of the automobile p and the average quality of used cars traded, p, or Qd= D (p, p). Both the supply of used cars and also the average quality p will depend upon the price, or p= p (p) and S= S(p). And in equilibrium the supply must equal the demand for the given average quality, or S(p) =D(p, p(p)). As the price falls, normally the quality will also fall. And it is quite possible that no goods will be traded at any price level. Such an example can be derived from utility theory.