The Market for Lemons — George Akerlof on Asymmetry, Uncertainty and Information

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The Market for Lemons — George Akerlof on Asymmetry, Uncertainty and Information

Cars and lemons

There is an important interplay between uncertainty and information in decision-making. Let us consider, for example, a simplified model of the market for second hand cars. Here, the seller knows more about the vehicle than the buyer. In particular, he knows whether his car is in good shape or bad. The buyer, on the other hand, does not. She only knows that there is some chance that the car is of either type. So she is left with no alternative but to discount her willingness to pay to minimize the risk that she buys a ‘lemon’ of a car.

Moreover, as the economist George Akerlof explains in The Market for Lemons, this asymmetry in information creates an “incentive for sellers to market poor quality merchandise.” Purveyors of shoddy cars enter the secondhand market, hoping to profit from the fact that buyers cannot distinguish between low and high quality. But if the buyer knows that the prevalence of slipshod cars is higher, her willingness to pay may fall even further. This in turn may ice out the sellers with well-kept cars, who prefer instead to retain their vehicle given the low market price. The result? As the economist David Autor explains, “if the share of lemons in the overall car population is high enough, the bad products drive out the good ones.” The market experiences a decline in quality.

Gresham’s law

Akerlof parallels this to Gresham’s law which states that “bad money drives out [the] good.” While we won’t get into the math here, the market for lemons arises because of the information asymmetry between buyers and sellers. If the buyer knew with certainty that she was dealing with a good car or a lemon, she would tailor her willingness-to-pay accordingly. But she does not, so she adjusts her single price in expectation.

Insurers, capitalists, and degrees

We can find lemons in many markets. Take insurance or venture capital, for instance. Here, insurers or capitalists may struggle to distinguish between risky and non-risky clients—so they charge higher premiums or rates-of-financing to protect themselves. As a result, the low-risk types who find the charges unacceptable may refuse insurance or capital. This in turn may raise the ratio of high-risk to low-risk people, which prompts insurers and capitalists to further increase their fees in expectation of greater danger.

So it is not surprising to see insurers and capitalists circumvent this by going to great lengths to understand the idiosyncrasies of their applicants. (But such differentiation may introduce another issue of its own. Now, the high-risk people most in need of insurance or capital cannot afford the higher price that their insurers and investors demand.)

A similar issue may arise in labor markets. Employers may have a hard time telling the difference between competent and incompetent candidates in a job interview. So some employers may rely on the candidate’s alma mater or qualification level to infer his or her capability.

As a result, talented prospects from impoverished schools or without formal education will find it harder to convey their suitability. This in turn may diminish their opportunities and experiences, which reaffirms and reinforces the average prejudices that employers hold about candidates from certain backgrounds. Yet, at the same time, untalented folk with financial means may pursue higher degrees to benefit from the signalling effect. In this way, the heuristics we use to grapple with uncertainty are imperfect and variable themselves. Higher degrees, in particular, may lose their informational advantage if they are held by large share of the incompetent. 

The price of asymmetry

Indeed, the interplay between uncertainty and information is widespread and persistent. So it is vital to remember that the nature of information in markets is special. It is not an everyday commodity like bread or wine. As Autor writes, information is non-rivalrous, durable, atypical, and difficult to measure. With information, you cannot ‘try before you buy’. Once it’s in your head, it is there. It is difficult to unlearn or destroy. And it can transmit at near-zero marginal cost from one person to another. Likewise, knowing that somebody knows or does not know something can change the entire game. 

In one sense, the market for lemons, Akerlof notes, can help us to understand the cost of asymmetry. As we’ve seen in automobiles, insurance, and employment, transactions that are pareto-improving under perfect information—that is, transactions that are beneficial to both parties when they are fully informed—may not occur when there are asymmetries. “The cost of dishonesty”, in particular, Akerlof writes, “lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”  

Full disclosure principle

Might there be a way out? Or are we doomed to a world of lemons? For one, the full disclosure principle tells us that it is possible to escape this dilemma. It suggests, as Autor explains, that “if there is a credible means for an individual to disclose that she is above the average of a group, she will do so.” Such disclosure tells us that those who do not disclose must therefore be below average. This in turn prompts others to disclose information to prove that they are not the worst of the remainder, which incentivises others to disclose as well. And so it goes.

Blaring bulls

To borrow a simple example from Autor, let us consider a swamp with a hundred male bullfrogs. To find a partner, the females listen to the croaks of the booming bachelors. Let us assume, for simplicity, that “the frog with the deepest croak attracts the best mate, and so on.” (We assume as well that the croaking depth of each male varies; and that the males know exactly where they rank amongst each other in terms of desirability.) The question is who will croak and who will not.

While many permutations appear possible at first, we know that the highest ranking bullfrog with the deepest voice will croak to secure the best mate. It follows that the second-ranked bullfrog will also croak to secure the second-best mate. And so on. This happens because the highest-ranking bullfrog that has not yet croaked has an incentive to reveal information about itself to win the best available mate. Sooner or later, a ruckus ensues—each bachelor croaking to his heart’s content. (The possible exception might be the frog with the weakest voice since it does not matter if he croaks or not. The behavior of everyone else has revealed his position.)

As Autor writes:

“The full disclosure principle is essentially the inverse of the lemons principle. In the lemon case, the bad products drive down the price of the good ones. In the full disclosure case, the good products drive down the price of the bad ones. What distinguishes these cases is simply whether or not there is a credible disclosure mechanism (and what the direct disclosure costs are).”

David Autor. (2004). Lecture — Private Information, Adverse Selection and Market Failure.

Bellows and merchants

Do the bullfrogs exhibit parallels to real life? Maybe. The point is that a sort of lock-in or rat-race may take place if people are motivated by relative standings. They may undertake pursuits to separate themselves from a homogenous pool. This may explain in part why people are obsessed with showcasing a curated version of themselves on Facebook, Instagram, LinkedIn, and other social media platforms. Perhaps we are not so different from the blaring bullfrog—we are all bellowing in our own ways to make it known that we are here.

More generally, the market for lemons reminds us that local knowledge, discernment, and credibility is vital to decision-making and functioning markets. “In production these skills are equally necessary—both to be able to identify the quality of inputs and to certify the quality of outputs,” writes Akerlof. Indeed, these are among the bottlenecks that plague market development in maturing economies. Because they lack access to established institutions, microfinancing in these regions, for example, may depend on intermediaries with strong local ties. Otherwise, lenders would not be able to offer better interest rates to reliable borrowers.

Mechanisms and trust

Society, however, has invented many more mechanisms to overcome the problem of lemons. Reputation and brand names, for example, enables the organization to signal its attributes to strangers—whether it be quality, honesty, and so on. Warranties and guarantees, likewise, can be an effective signal as well. After all, we would not expect the gimcrack supplier to guarantee its output if it would put them at a loss. Of course, lemons can infiltrate every level of interaction and information. Bad people, bad companies, and bad politicians are fond of making claims and promises they cannot possibly keep. 

As such, the quality of discernment and credibility depends on our institutions and its ability to disincentivize wrongdoing. We sometimes forget that the trust we place in our licensed doctors, dentists, lawyers, teachers, and so on, rely on the very systems that regulate them. The layperson in a large city would otherwise struggle to know if he or she is dealing with a professional or a crank. Just imagine the anarchy if the licensing rules for pilots, builders, or police officers were to disappear overnight.

You see, core to all this, from local relationships to impersonal institutions, is the role of trust. It is the connective tissue of a market economy and the invisible hand. Ideologues should therefore remember that it is not just self-interest that promotes the virtues and efficiencies of free-markets, but the many forms in which trust manifests itself. We would otherwise live in a world of lemons and charlatans, unable to discern who from who.

Sources and further reading

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