Economics 1970

The Market for “Lemons”: Quality Uncertainty and the Market Mechanism

George A. Akerlof

When sellers know more than buyers, bad goods can drive out the good — until the market unravels.

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In depth · the introduction

Why is a car worth thousands less the moment you drive it off the lot — even if nothing about it has changed?

The big idea

Sometimes the seller knows something the buyer can't — the true condition of a used car, say. If buyers can't tell a good car from a hidden dud (Americans call a bad car a “lemon”), they'll only offer a middling, average price. But that price is an insult to whoever has a genuinely good car, so those owners keep their cars off the market.

Now only the worse cars are left for sale — which means the real average just dropped, so buyers offer even less, which chases off the next-best cars, and so on. The good is driven out by the bad. In Akerlof's sharpest example, the spiral runs all the way down: the market can shrink to nothing, even though every buyer would happily have paid a fair price for a good car. The villain isn't greed or monopoly — it's a gap in who-knows-what.

How it came about

George Akerlof was a young economist, just a few years out of his PhD, when he wrote this short paper in the late 1960s. He chose used cars not because they mattered most, but because the example was vivid and easy to grasp; the real targets were bigger — why credit is so hard to get in poor countries, why insurance is tricky, why some markets barely exist.

The idea was so simple, and so unlike the tidy supply-and-demand models of the day, that several journals turned the paper down — one reportedly said that if it were true, economics would be different, and another that it was too trivial. The Quarterly Journal of Economics finally published it in 1970. Three decades later it helped win Akerlof a share of the Nobel.

Why it mattered

For two centuries economics had mostly assumed buyers and sellers knew what they were trading. Akerlof showed that when they don't — when information is lopsided — even a perfectly competitive, honest-intentioned market can fail, leaving everyone worse off. That cracked open a whole new field. It also explained, at last, the everyday institutions we'd built without quite knowing why: warranties, brand names, professional licences, the reason a stranger's promise is worth less than a regular's.

A way to picture it

Imagine a fruit stall where every apple is wrapped in foil. You can't see which are crisp and which are bruised, so you'll only pay the price of an average apple. But anyone holding a perfect apple won't sell at that price — they take theirs home. So the stall fills with bruised ones, the foil hiding it all, and the average sinks. Soon you won't pay even the average. Pull the foil off — let buyers see the quality — and the stall springs back to life. That foil is asymmetric information.

Where it sits

Adam Smith's invisible hand (also in this Library) said self-interested trade quietly serves everyone — when both sides can see what they're getting. Akerlof found a crack in that picture: hide the quality, and the hand can falter. His paper is one of a trio — with Michael Spence on signalling and Joseph Stiglitz on screening — that built the economics of information and shared the 2001 Nobel. Every time you check a seller's rating online, you're using the institutions that grew out of this idea.

The original document

Original source text

I. Introduction

George A. Akerlof · The Quarterly Journal of Economics 84(3) (1970): 488–500

This paper relates quality and uncertainty. The existence of goods of many grades poses interesting and important problems for the theory of markets. On the one hand, the interaction of quality differences and uncertainty may explain important institutions of the labor market.

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market.

II.A. The automobiles market

II. The Model with Automobiles as an Example · A. The Automobiles Market

The example of used cars captures the essence of the problem. … We offer a different explanation. Suppose (for the sake of clarity rather than reality) that there are just four kinds of cars. There are new cars and used cars. There are good cars and bad cars (which in America are known as “lemons”). A new car may be a good car or a lemon, and of course the same is true of used cars.

After owning a specific car, however, for a length of time, the car owner can form a good idea of the quality of this machine … An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers. But good cars and bad cars must still sell at the same price — since it is impossible for a buyer to tell the difference between a good car and a bad car.

Gresham's law has made a modified reappearance. For most cars traded 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 same way that bad money drives out the good).

But the analogy with Gresham's law is not quite complete: bad cars drive out the good because they sell at the same price as good cars … only the seller knows. In Gresham's law, however, presumably both buyer and seller can tell the difference between good and bad money. So the analogy is instructive, but not complete.

III. The cost of dishonesty

III. Examples and Applications · The cost of dishonesty

The purchaser's problem, of course, is to identify quality. The presence of people in the market who are willing to offer inferior goods tends to drive the market out of existence — as in the case of our automobile “lemons.”

It is this possibility that represents the major costs of dishonesty — for dishonest dealings tend to drive honest dealings out of the market. … The cost of dishonesty, therefore, 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.

IV–V. Counteracting institutions; conclusion

IV. Counteracting Institutions · V. Conclusion

Numerous institutions arise to counteract the effects of quality uncertainty. One obvious institution is guarantees. … A second example … is the brand-name good. … Licensing practices also reduce quality uncertainty. … The high school diploma, the baccalaureate degree, the Ph.D., even the Nobel Prize, to some degree, serve this function of certification.

We have been discussing economic models in which “trust” is important. Informal unwritten guarantees are preconditions for trade and production. Where these guarantees are indefinite, business will suffer — as indicated by our generalized Gresham's law.

University of California, Berkeley · Indian Statistical Institute, New Delhi · 1970