SummaryIn this LP we cover the implications of asymmetrical information, looking at the most important examples. We start by looking at adverse selection, then we learn more about moral hazard.
“The Market for ‘Lemons’” is a key article written by George Akerlof in 1970, which aims to explain some of the market failures derived from imperfect information, in this case asymmetry. The paper itself is available on the bibliography and is characterised by its approachability and humour: as Akerlof himself stated, he lacked the mathematical dexterity to fully model the problem (although this has later been done by a host of economists, of which Hal Varian’s analysis is probably the most well known).
We are presented with the problem of someone who wants to buy a car, and decides to scout the used car market for a bargain. The market itself is composed of two types of cars: those that are being sold in good faith and those that are being sold off because they are known to be unreliable: these are the ‘lemons’ (in US slang). The seller, of course, knows how good the car is: they’ve had time to decide. The buyer, however, comes to the market blind: all they have to go on is the average quality of the used car market (which Akerlof defines as μ) and the price of the car, p. Obviously, all similar models of cars need to be sold for an identical price, p. If we sell below market price, be it a lemon or not, we are sending out signals that the car is worth less than the market price, leading buyers to assume it is a lemon. However, it is also logical to assume that, if we know the car we are selling is reliable, we will want more than the average market price, because that average includes a proportion of lemons.
Therefore, two prices are naturally set up: one for the lemons (say 1000$), and one for the good cars (sometimes called ‘cherries’ or ‘plums’), say 2500$. Below these prices, the seller will not be willing to let go of their vehicle and would derive greater utility from keeping it. Above this price, they would rather sell. The problem is, therefore, that competition will naturally drive down the price to one below which the honest seller are willing to go. Buyers will not be willing to pay 2500$ knowing that there is a probability that what they are buying is really a lemon: they need to reflect the premium related to the uncertainty derived from the asymmetrical information in a lower price. Lemon seller will be able to assume this drop in price, all the way down to 1000$, but honest sellers will not. Eventually, all that will be left in the market will be an orchard of lemons, but no cherries nor plums.
Analytically, if the quality of lemons is 0 and the quality of cherries is 1, and there are equal amounts of each, then
Buyers are willing to pay up to 3/2 q for a car with quality equal to q, and sellers are willing to sell for q (we are assuming p=q for simplicity’s sake, but the ratio could be any we decide to set). This means that, as
which means that no cars will be sold.