The Market for “Lemons”: Quality Uncertainty & the Market Mechanism Akerlof

The Market for “Lemons”:Quality Uncertainty & the Market Mechanism Akerlof Presented By: Ahmed Mujtaba Ahmed Raza Annan Saeed Dilawar Qazi Haad Khan Rizwan Khan Tanveer Khan

The Idea • This paper relates quality and uncertainty. • Information asymmetry • The bad driving out the good" in the market • seller have incentive to sell inferior goods when the quality of goods is difficult to identify. • When the buyer is less informed about the quality than the seller, adverse selection may result.

Market for Used Cars • This paper has taken the automobile market to illustrate the points • There are good used cars (cherries) and defective used cars (lemons)

Normally as a consequence of several not-always-traceable variables such as the owner's driving style, quality and frequency of maintenance and accident history car quality falls (lemons) • Because the buyer cannot tell the difference, bad cars and good cars have to be sold at the same price. • Good car owners are locked in while lemons stay on the market.

EXAMPLES OF AUTOMOBILES

Bad cars are denoted by lemon Sellers betray their customers This is common practice through out the world. Sellers predict that they are selling good quality cars but in real they give lemon. Customers gets betrayed because of the asymmetrical informantion

The demand for used cars depend on their quality and price. • Mostly dependant on price.

Asymmetrical information • It is one of the factor that the buyers get betrayed sometimes and don’t get the model he is looking far .

Important point : • just like we are discussing dishonesty in the business world, the world will collapse if it doesn’t stop.

The sellers gets advantage while the buyer doesn’t get full utility. • The other factor is symmetrical inofrmation

If Information is Symmetric • Note there is a maximum utility gain if the equilibrium is established at symmetric information • With asymmetric information, no trade takes place

Examples and Applications Insurance: It is a well known fact that people over 65 years of age have great difficulty in buying medical insurance. Now why the price does not rise to match the risk? The answer is.. ☻But at average the result.. ■ Generally speaking policies are not available for at age greater then 65 years.

Now the conclusion is that insurance company are worry about giving medical insurance to older people. • Here the principle of adverse selection is present in fact it is present in all lines of insurance. • Adverse selection? • Adverse selection appears whenever the individual or group insured has freedom to buy or not to buy or plan of insurance or to discontinue as a policy holder.

In USA adequate health is the precondition for employment which means the medical insurance is least available to those who need it most so it means insurance companies do their own adverse selection. • On cost benefit basis: attracts too many lemons

The employment of minorities • Employer may refuse to hire members of minorities groups for certain types of jobs. • Profit maximization not irrationality • To serve a good statistic for applicant’s social background, quality of schooling, and general job capabilities are important. • The capabilities of children and mature student: • Through educational establishment (e.g an untrained worker with valuable natural talent)

Unreliability of slum schools: • Rational decision • Benefit from training minority groups: • by raising average quality • by raising individual quality • But return may be distributed over the whole group.

Real World Cost of dishonesty • The presence of people who sell inferior goods tends to drive out the legitimate business. It is not only are the consumers cheated but also moral and legal concerns rise. • Expertise to tell the true value of undistinguishable goods is easily directed to arbitrage rather than real production purpose because the former is more profitable in a world full of lemons.

Counteracting institutions • Numerous institutions arise to counteract the effects of quality uncertainty. • one natural result of our model is that the risk is borne by the seller rather than by the buyer. • Institution which counteracts the effects of quality uncertainty is the BRAND names. • Brand names not only indicates but also give the consumer a means of retaliation if the quality does not meet the expectations.

Cont…… • New products are associated with old brand names. This ensure the prospective consumer of the quality of the product. • Chains- such as hotel chains or restaurant chains are similar to the brand names. • Licensing practices also reduce quality uncertainty. For example the licensing of the doctors, lawyers, and barbers. • Most skilled labor carries some certification indicating the attainment of certain levels of proficiency.

Real World Credit market in underdeveloped countries • Entrepreneurs have to turn to “managing agencies”, people and companies with reputation and communal influence, for financing a newly started firm. • Rural credit market is dominated by loans with extortionate rates from local moneylenders rather than those with official rates from formal banks since only the former have good access to borrower’s information. Anyone who try to arbitrage tends to lose.

Conclusion • Trust is important • Business will suffer as indicated by our genralized gresham’s law but • The difficulty of distinguishing good quality from bad is inherent in the business world

The Market for “Lemons”: Quality Uncertainty & the Market Mechanism Akerlof