A Market for Lemons Charles A. Holt Roger Sherman

Market Failure Under Asymmetric Information  1970, George Akerlof, publishes The Market for "Lemons": Quality Uncertainty and the Market Mechanism The Quarterly Journal of Economics, Vol. 84, No. 3. (Aug., 1970)

Akerlof’s Lemons  When product quality is unobservable by buyers, sellers will lower product quality.  Buyers will expect sellers to “skimp” on quality, and they lower their willingness to pay.  Prices will decline.  In turn, sellers will be forced to lower quality even further to make profits at the lower prices.  Thus, quality will decline until nothing but the lowest quality lemons are left.

Akerlof’s Lemons  Thus, the market fails!  Sellers cannot sell high quality goods at high prices even though buyers would be willing to pay the high prices for the high quality goods!

The Model (in brief)  An object has value  This value is known a priori to the seller.  A buyer does not know, but does know that  The buyer finds out the true value of v only after he has purchased the object. (and, then it’s too late! No refunds!)

The Model (in brief)  The seller’s utility is:  The buyer’s utility is:  With So trading is always Pareto-optimal.

The Model (in brief)  The seller sells if:  Thus, by selling the object, he signals:

The Model (in brief)  The buyer buys if:  And, he knows that

The Model (in brief)  So, the buyer buys if:  and,  So,

The Model (in brief)  Thus, trade occurs only if  Having is not enough.  If but, the market FAILS.

The Classroom Experiment

Quality Grade 1 Quality Grade 2 Quality Grade 3

The Best

Let’s Look at Our Results

Hold and Sherman’s Results

Complete Market Failure