A Market for Lemons
Charles A. Holt
Roger Sherman
Market Failure Under Asymmetric
Information

1970, George Akerlof, publishes
The Market for "Lemons": Quality
Uncertainty and the Market
Mechanism
The Quarterly Journal of Economics,
Vol. 84, No. 3. (Aug., 1970)
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.
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!
The Model (in brief)

An object has value v  [0,1]

This value is known a priori to the seller.

A buyer does not know v,
but does know that v ~ U [0,1]

The buyer finds out the true value of v only
after he has purchased the object.

(and, then it’s too late! No refunds!)
The Model (in brief)

The seller’s utility is:
us  p   s v

The buyer’s utility is:
ub  bv  p

With b   s

So trading is always Pareto-optimal.
The Model (in brief)

The seller sells if:
us  p   s v  0
sv  p

Thus, by selling the object, he signals:
p
v
s
The Model (in brief)

The buyer buys if:
E ub   E bv  p  b E v  p  0
b E  v   p

And, he knows that
p
v
s
and
v ~ U [0,1]
The Model (in brief)

So, the buyer buys if:
b E  v | p   p

and,

So,
p
E v | p  
2 s
b E  v | p   p

p
b 
p
2 s
The Model (in brief)

Thus, trade occurs only if
b  2 s

Having b   s is not enough.

If b   s but b  2 s , the market FAILS.
The Classroom Experiment
Quality
Grade 1
Quality
Grade 2
Quality
Grade 3
The Best
Let’s Look at Our Results
Hold and Sherman’s Results
Complete
Market Failure