Akerlof's market for lemons theory describes how asymmetric information between buyers and sellers in a market can cause market failure. When buyers cannot reliably assess the quality of goods for sale, they will assume the average quality is lower and be unwilling to pay high prices. This forces sellers to lower prices which then incentivizes them to lower quality further. The market may reach a point where only low quality "lemons" remain for sale, even though buyers would pay more for higher quality goods if quality could be verified.

1. A Market for Lemons

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

3. 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.

4. 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!

5. LETS TAKE SECOND HAND CARS AS AN EXAMPLE Second hand cars can be classified into 2 categories : Lemons Plums

6. LEMONS A lemon is typically a euphemism for a bad car Try to avoid choosing a lemon when you use the second hand car market!

7. PLUMS A plum is used as a euphemism for a good quality car Obviously every buyer would desire a ‘Plum’ =

8. Sample size = 100 50 LEMONS 50 PLUMS

9. SELLER’S PRICE EXPECTATIONS LEMONS - $1000 PLUMS - $2000

10. BUYERS ARE WILLING TO PAY LEMONS - $1200 PLUMS - $2400

11. If it were easy to verify quality then there would be absolutely no problem. The ideal equilibrium price for lemons would be between $1000 - $1200 The ideal equilibrium price for plums would be between $2000 - $2400 Unfortunately there is no assurance of quality and hence prospective buyers must make an informed guess about quality.

12. If a buyer were to assume that there will be an equal probability of getting either a plum or a lemon, then the buyer would be willing to pay : ½ (1200) + ½ (2400) = 1800 The average price that the buyer is willing to pay is less than the average price that a seller will demand for lemons At $1800, only lemons would be offered for sale

13. But if a buyer were certain that they were getting a plum, they would be willing to pay anywhere between $2000 - $2400 Even though the price at which buyers are willing to buy plums exceeds the price at which sellers are willing to sell them, no such transaction will take place.

14. 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!)

16. Moral Hazard is the lack of incentive to take care. It works on the premise that you believe that if you have insurance then the cost of the theft is less. Less Insurance = More Risk More Insurance = Less Care

17. THE PERFECT EXAMPLE?? NO ATTENDANCE TO LATECOMERS!