The Market for "Lemons": Quality Uncertainty and the Market Mechanism Author(s): George A. Akerlof Source: The Quarterly Journal of Economics, Vol. 84, No. 3 (Aug., 1970), pp. 488-500 Published by: The MIT Press Stable URL: http://www.jstor.org/stable/1879431 Accessed: 22/10/2010 23:04
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THE MARKET FOR "LEMONS": QUALITY UNCERTAINTY AND THE MARKET MECHANISM* A. GEORGE AKERLOF
I. Introduction, 488.-II. The model with automobiles as an example, 489.- III. Examples and applications, 492.- IV. Counteracting institutions, 499. -V. Conclusion, 500. I. INTRODUCrION

This paper relates quality and uncertainty. The existence of goods of many gradesposes interestingand importantproblemsfor the theory of markets. On the one hand, the interactionof quality differencesand uncertainty may explain important institutions of the labor market. On the other hand, this paper presents a struggling attemptto give structureto the statement:"Businessin underdevelopedcountriesis difficult";in particular,a structureis given the for determining economiccosts of dishonesty. Additionalappliof the theory include commentson the structureof money cations markets, on the notion of "insurability,"on the liquidity of durgoods. ables, and on brand-name are many markets in which buyers use some market There statistic to judge the quality of prospectivepurchases. In this case there is incentive for sellers to market poor quality merchandise, since the returnsfor good quality accruemainly to the entire group whose statistic is affected rather than to the individual seller. As a result theretends to be a reductionin the averagequality of goods and also in the size of the market. It should also be perceivedthat in these marketssocial and private returnsdiffer,and therefore,in interventionmay increasethe welfare of some cases, governmental all parties. Or private institutions may arise to take advantage of the potentialincreasesin welfarewhich can accrueto all parties. By nature,however,these institutionsare nonatomistic,and thereof of fore concentrations power- with ill consequences their owncan develop.
*The author would especially like to thank Thomas Rothenberg for invaluable comments and inspiration. In addition he is indebted to Roy Radner, Albert Fishlow, Bernard Saffran, William D. Nordhaus, Giorgio La Malfa, Charles C. Holt, John Letiche, and the referee for help and suggestions. He would also like to thank the Indian Statistical Institute and the

support. for Ford Foundation financial

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The automobilemarketis used as a fingerexerciseto illustrate that this maranddevelopthese thoughts. It shouldbe emphasized rather ket is chosen for its concretenessand ease in understanding thanfor its importanceor realism.
AS II. THE MODELWITH AUTOMOBILES AN EXAMPLE

A. The AutomobilesMarket The exampleof used cars capturesthe essence of the problem. Fromtime to time one hears either mention of or surpriseat the largeprice differencebetween new cars and those which have just left the showroom. The usual lunch table justification for this is phenomenon the pure joy of owning a "new" car. We offer a explanation. Suppose (for the sake of clarity rather than different reality)that there are just four kinds of cars. There are new cars andused cars. There are good cars and bad cars (whichin America areknownas "lemons"). A new car may be a good car or a lemon, andof coursethe same is true of used cars. The individualsin this market buy a new automobilewithout whetherthe car they buy will be goodor a lemon. But they knowing doknowthat with probabilityq it is a goodcar and with probability (1-q) it is a lemon; by assumption,q is the proportionof good of and (1 - q) is the proportion lemons. carsproduced After owning a specific car, however,for a length of time, the carownercan form a good idea of the quality of this machine;i.e., the ownerassigns a new probabilityto the event that his car is a lemon.This estimate is more accurate than the original estimate. An asymmetry in available information has developed: for the sellersnow have more knowledgeabout the quality of a car than the buyers. But good cars and bad cars must still sell at the same -since it is impossiblefor a buyer to tell the differencebeprice tweena good car and a bad car. It is apparentthat a used car cannothave the same valuation as a new car- if it did have the same valuation,it would clearly be advantageousto trade a lemon at the price of new car, and buy anothernew car, at a higher probabilityq of being good and a lowerprobabilityof being bad. Thus the owner of a good machine must be locked in. Not only is it truethat he cannot receive the true value of his car, but he cannot evenobtain the expectedvalue of a new car. Gresham'slaw has made a modified reappearance.For most carstraded will be the "lemons,"and good cars may not be traded at all. The "bad" cars tend to drive out the good (in much the

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same way that bad money drives out the good). But the analogy with Gresham'slaw is not quite complete: bad cars drive out the goodbecausethey sell at the same price as good cars; similarly,bad money drives out good becausethe exchangerate is even. But the bad cars sell at the same price as good cars since it is impossible for a buyer to tell the differencebetween a good and a bad car; both law, however,presumably only the seller knows. In Gresham's tell the difference between good and bad buyer and seller can money. So the analogy is instructive,but not complete.
B. Asymmetrical Information

It has been seen that the good cars may be driven out of the marketby the lemons. But in a morecontinuouscase with different grades of goods, even worse pathologiescan exist. For it is quite possibleto have the bad driving out the not-so-baddriving out the medium driving out the not-so-gooddriving out the good in such a sequenceof events that no marketexists at all. One can assumethat the demandfor used automobilesdepends p most strongly upon two variables- the price of the automobile and the averagequality of used cars traded,a, or Qd = D (p, A). Both the supply of used cars and also the average quality p will depend the upon the price, or p=j (p) and S=S(p). And in equilibrium supply must equal the demand for the given average quality, or S(p) = D (p, p (p)). As the price falls, normally the quality will also fall. And it is quite possible that no goods will be tradedat any price level. Such an example can be derived from utility theory. Assume that there are just two groupsof traders: groupsone and two. Give groupone a utility function
U1=M+ iXi
_.1

x4 where M is the consumptionof goods other than automobiles, autois the quality of the ith automobile,and n is the numberof mobiles. Similarly,let U2= M+
X
i.i

3/2x4

whereM, xi, and n are definedas before. Three comments should be made about these utility functions: (1) without linear utility (say with logarithmicutility) one gets needlessly mired in algebraic complication. (2) The use of

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linearutility allows a focus on the effectsof asymmetryof information; with a concaveutility functionwe would have to deal jointly with the usual risk-varianceeffects of uncertainty and the special effectswe wish to discuss here. (3) U1 and U2 have the odd characteristicthat the addition of a second car, or indeed a kth car, addsthe same amountof utility as the first. Again realismis sacrificedto avoid a diversionfromthe properfocus. To continue,it is assumed (1) that both type one traders and maximizers of type two traders are von Neumann-Morgenstern that group one has N cars with uniformly expectedutility; (2) quality x, 0