A Market for Lemons

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

A Market for Lemons