George Akerlof The Market for Lemons

Asymmetric Information Sellers knows quality of good she offers for sale, buyer does not

Selling a used car There are 6 cars in the economy with qualities 0 .4 .8 1.2 1.6 2 Even though the qualities are different, all cars looks the same. In the market all cars sell for the same price because all cars look the same, AND sellers cannot be trusted The average quality of a car offered for sale is known

Two types of people Type1 will sell a car of quality q if she can get for it at least q*$1,000. For example, the person who has a car with q=.8 will sell it if the price of a car (all cars sell for the same price) is at least .8*$1,000= $800. Type 2 will buy a car of average quality q if the price is less than 1.5*(average quality)*1,000. For example, if the average quality of a car is 1, the buyer will be willing to pay for it up to $1,500.

What is the highest possible price for a car in this market What is the highest possible price for a car in this market? How many cars will be offered for sale at this price? How many cars will be bought?

Price is $900 How many cars will be sold? At that price all owners with cars of quality .9 or below will offer them for sale. The qualities of these cars are: 0 .4 .8 The average quality of a car offered for sale is .4

Will buyers buy these cars? When the price is $900, a buyer will buy only if $900< .4*$1,000*1.5=$600? This inequality does not hold, and therefore none of the cars will be sold.

The collapse of the market is Pareto Inefficient If only cars of qualities .4 .8 were offered for sale, then in each case there would have been winners. In all these cases the winners would have been the sellers, because the consumer surplus from a car of average quality .6 is zero Alternatively, if only car .8 were offered for sale, then buyers would have been better off because average q is .8, and sellers would have been better off because price exceeds their reservation price.

Examples No health insurance for old people (adverse selection) Group insurance through the employer (employed people are healthier, the people who need insurance the most, the unemployed, do not have it, because they have to pay a higher premium.) No car rentals for people younger than 25

Worked Out Example No health insurance for old people (adverse selection) There are four persons with the following health costs outcome, in million, each outcome has a .1,.9 probability: 0.1,2; 0.1,2; 0.2,2; 2,2 Each person is willing to pay 1.5 times her expected cost as premium, except the really sick person who agrees to pay 2.

The benefit of Raising the Bottom “An additional worry is that the Office of Economic Opportunity is going to use cost-benefit analysis to evaluate its programs. For many benefits may be external. The benefit from training minority groups may arise as much from raising the average quality of the group as from raising the quality of the individual trainee; and, likewise, the returns may be distributed over the whole group rather than to the individual.” In car example, raising the quality of the 0 car to . 6 would have resulted in a Pareto Improvement.

Banks, Airlines, Pharmaceuticals Regulation is a method of raising the bottom and preventing market collapse

Counteracting Institutions Warranties Brand names Chain stores What is the solution for health insurance? (Why is there car insurance for young drivers who drive their own cars, but not for rentals?)

Market Failure When the regular operation of a market leads to a Pareto inefficient result, this is called Market Failure