George Akerlof’s 1970 paper “The Market for ‘Lemons’” introduced a groundbreaking economic concept that explains how information asymmetry affects markets. Here’s a detailed summary:
Core Concept
Akerlof demonstrates how markets can fail when buyers and sellers have asymmetric information about product quality. His primary example is the used car market, where sellers know much more about their cars’ quality than buyers do.
The Used Car Market Example
- Sellers know whether their used cars are good quality or “lemons” (defective cars)
- Buyers cannot distinguish quality before purchase
- This information asymmetry leads rational buyers to assume that any given car might be a lemon
- Buyers therefore only offer a price reflecting the average expected quality
- This price is too low for sellers of good cars, who withdraw from the market
- Only sellers of lemons remain willing to sell at the lower price
- This further reduces average quality, pushing prices lower
- The cycle continues until the market potentially collapses entirely
Mathematical Model
Akerlof formalized this with a model where:
- Cars have quality q uniformly distributed from 0 to 2
- Sellers value their car at q
- Buyers value the same car at 1.5q
- Even though every transaction could create value (since buyers value cars more than sellers), information asymmetry prevents many beneficial trades
Broader Applications
Akerlof extends this analysis to multiple markets:
- Insurance markets: Why elderly struggle to get health insurance
- Labor markets in developing countries: How discrimination and statistical discrimination function
- Credit markets in developing nations: Why lenders charge high interest rates
- Business in underdeveloped countries: Why entrepreneurship struggles
Counteracting Institutions
Akerlof identifies institutions that emerge to combat information asymmetry:
- Guarantees/warranties: Signals of product quality
- Brand names: Reputation mechanisms that signal consistent quality
- Licensing/certification: Third-party verification of quality
- Chain establishments: Standardization that reduces uncertainty
Significance
The paper demonstrates that information problems can cause entire markets to function poorly or fail completely. This challenged traditional economic assumptions of perfect information and helped create the field of information economics.
This work was revolutionary and eventually contributed to Akerlof receiving the Nobel Prize in Economics in 2001, shared with Michael Spence and Joseph Stiglitz for their work on markets with asymmetric information.