THE MARKET FOR "LEMONS":QUALITY UNCERTAINTY AND THE MARKET

MECHANISM

Presented by Jong-Kyung Park

Koshland Professor of Economics at the University of California, Berkeley

2001 Nobel Prize in Economics

MIT (Ph.D.) ; Yale University (B.A.)

GEORGE A. AKERLOF (1970)

The need for research

• Microeconomic theory models in the 1960s were characterized by their generic nature they dealt with perfect competition and general equilibrium.

• Situational and specific considerations were left out (such as information asymmetries)

• The existence of goods of many grades poses interesting and important problems for the theory of markets.

Research Purpose

• The paper relates quality and uncertainty.

• Exploring the interaction of quality differences and uncertainty in explaining important institutions of the labor market.

• Giving structure to the statement: "Business in under-developed countries is difficult.”

• Determining the economic costs of dishonesty.

• Applications: Insurability; Brand names, etc.

•Large price difference between new cars and those which have just left the showroom

•After owning a specific car for a length of time, the car owner can form a good idea of its quality.

•This estimate is more accurate than the original estimate.

•An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers.

Information Asymmetry – Automobile Market

“Bad money drives out good.”

•When a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation•If coins containing metal of different value have the same value as legal tender, the coins composed of the cheaper metal will be used for payment, while those made of more expensive metal will be hoarded or exported and thus tend to disappear from circulation.

Gresham’s law

Lemon Market Model

Where: M is the consumption of goods other than automobiles, xi is the quality of the ith automobile, and n is the number of automobiles.

Model with Information Asymmetry

Demand-Supply for group 1 Demand-Supply for group 2

Demand Curve Supply Curve

Model with Information AsymmetryTable : Demand and Supply in Asymmetric Case

• The average quality of cars is only a half of the offering price.

The buyer is uncertain about the quality of cars

• Group 1 only wants to pay at P/2, while group 2 only wants to pay at 3/4p.

No cars will be sold at price p.

• The price would go down, which further drives some sellers out of the market and further lowers down the average quality of cars, leading to the shrinking of the market.

Model with Information Symmetry

Supply Demand

Table : Demand and Supply in Asymmetric Case

Model with Information Symmetry

• There is no equilibrium when price is above 3/2, because group 1 is willing to sell their car, but no group is willing to buy, since the reservation price of group 2 is only 3/2 and group 1 is only 1.

• When price is 3/2, only group 2 wants to buy the car, because price is still above the reservation price of group 1

• When price falls below 1, the equilibrium doesn't exist since group 1 doesn't want to supply/ sell their cars.

Equilibrium of Supply and Demand in Symmetric Case

• People over 65 have great difficulty in buying medical insurance.

• Why doesn't the price rise to match the risk?

As the price level rises, the people who insure themselves will be those who are increasingly certain that they will need the insurance.

• As a result, the average medical condition of insurance applicants deteriorates as the price level rises.

• Consequently, no insurance sales may take place at any price.

Insurance

One possible solution for adverse selection Group insurance

• Race may serve as a good statistic for the applicant's social background, quality of schooling, and general job capabilities.

Despite the fact that agents behave rationally and also do not exhibit prejudices, demographic groups still are unequal “when compared to other demographic groups”.(Kenneth Arrow)

• The fact that some demographic groups are preferred to others is because employers make judgments about the average behavior of an observable group of people.

• Quality schooling may be a substitute for this statistic. Workers with high ability have lower costs of pursuing attainment

of education at higher levels, which can act as a signal of their productive capacity.

Employment of Minorities

• In the example for the used car market, there is an incentive for the sellers to offer lemons at the market price. This lowers the expected quality of a good from the perspective of consumers; this drives legitimate goods out of business.

• Dishonest dealings tend to drive honest dealings out of the market.

• The cost of dishonesty lies not only in the amount by which the purchaser is cheated but also the cost of loss incurred from driving legitimate business out of existence.

• Empirical evidence suggests that developing countries are subject to much greater variations in quality.

Cost of Dishonesty

• In India a major fraction of industrial enterprise is controlled by managing agencies.

Promoter would turn to the agency because of its reputation, which would encourage confidence in the venture and stimulate investment.

• If the Agency green lights the venture, then it is able to attract investment, simply by way of being certified by said agency.

This works because the Agency would have established a reputation of credibility, can effectively act as a screening agent.

• The local moneylender charges Extortionate rates to his clients.

• Cooperative Movement was meant to compete with local money lender.

• If the middleman tries to arbitrage between the rates of the moneylender and the central bank, it will attract all the "lemons" and thereby make a loss.

Creates a barrier for entry in the market.

Credit Market in Underdeveloped Countries

• Institutions arise to counteract the effects of quality uncertainty

Counteracting Institutions

• Informal unwritten guarantees are preconditions for trade and production.

Where these guarantees are indefinite, business will suffer as indicated by generalized Gresham's law.

• The difficulty of distinguishing good quality from bad is inherent in the business world.

• Institutions emerge to mitigate this uncertainty.

Conclusion

• Consider case that consumers can seek ways to assure the quality for themselves.

• A used-car salesperson may work to maintain his reputation rather than pass off a "lemon".

Reputation is usually a good asset if one intend to continue business in the market.

• Libertarians argued some used-car markets haven't broken down even without lemon legislation and that the lemon problem creates entrepreneurial opportunities for alternative marketplaces.

Discussion