Market for Lemons

George Akerlof developed the idea of the market for lemons to explain problems related to information asymmetries in markets. “Lemons” refer to used cars that are of poor quality. If there are two types of cars on the market—those of high quality (“cherries”) and those of low quality (“lemons”)—and the buyers and sellers can easily determine which category a cars falls into, then both types of cars will be sold and high-quality cars will sell for a higher price than low-quality cars. In the real used-car market, however, there is an information asymmetry problem because the sellers of cars know more about the quality of cars than the potential buyers. Because the quality of a used car may be difficult and costly for the buyer to determine (and the seller may still have an information advantage due to actual experience with the car), the buyer will want to avoid the risk of paying a high price for a low-quality car. To do this, the buyer will assume that all cars are of an average quality. This assumption will cause the demand curve for highquality cars to shift down (decreasing the supply of high-quality cars), but cause the demand curve for lowquality cars to shift upward (increasing the supply of low-quality cars). Over time, this shifting of the demand curves will continue to occur until only low-quality cars are sold. This is a market failure because there is no longer a choice of cars of various quality levels for the consumer to choose from. Instead, only sellers of “lemons” will be participating in the market.

The above analysis can also apply to the markets for health insurance, financial credit, and other markets with information asymmetry problems. In health insurance, for example, the buyers of insurance will have an advantage over sellers with respect to information on the quality of the buyer's health. As a result, unhealthy buyers purchase insurance at the price of an “average” buyer, which then forces up the price of insurance and causes healthy buyers to choose not to be insured (which further increases the proportion of unhealthy buyers as holders of insurance). Over time, the market fails. This problem is referred to as adverse selection.

Potential solutions to the lemons problem include signaling and developing a positive reputation. Signaling involves actions that allow sellers to distinguish their high-quality products from sellers of low-quality products, although buyers cannot determine the level of quality until after they make a purchase. For example, sellers of high-quality cars could offer a warranty or money-back guarantee on their car because they know that buyers will rarely need to use the warranty or guarantee after a purchase. Sellers of low-quality cars, on the other hand, could not afford to offer such warranties, because buyers would exercise those rights and create additional costs for the seller. Thus, the presence of a warranty may provide a useful signal to buyers as to the true quality of the car and they will no longer make the assumption that all cars are of average [Page 1336]quality. Likewise, if the seller develops a positive reputation, then buyers may be willing to trust the seller's statements as to the quality of the car and avoid the market for lemons problem.

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