The Market for Lemons
From Wikipedia, the free encyclopedia
 |
This article needs additional citations for verification. Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (February 2008) |
"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper by the economist George Akerlof. It discusses information asymmetry, which occurs when the seller knows more about a product than the buyer.
Akerlof, Michael Spence, and Joseph Stiglitz jointly received the Nobel Memorial Prize in Economic Sciences in 2001 for their research related to asymmetric information.
Contents |
[edit] Asymmetrical information
The paper by Akerlof describes how the interaction between quality heterogeneity and asymmetrical information can lead to the disappearance of a market where guarantees are indefinite. In this model, as quality is undistinguishable beforehand by the buyer (due to the asymmetry of information), incentives exist for the seller to pass off low-quality goods as higher-quality ones.
The buyer, however, takes this incentive into consideration, and takes the quality of the goods to be uncertain. Only the average quality of the goods will be considered, which in turn will have the side effect that goods that are above average in terms of quality will be driven out of the market. This mechanism is repeated until a no-trade equilibrium is reached.
As a consequence of the mechanism described in this paper, markets may fail to exist altogether in certain situations involving quality uncertainty. Examples include the market for used cars, the dearth of formal credit markets in developing countries[dubious ] and the unavailability of health insurance for the elderly[dubious ].
However, not all players in a given market will follow the same rules or have the same aptitude of assessing quality. So there will always be a distinct advantage for some vendors to offer low-quality goods to the less-informed segment of a market that, on the whole, appears to be of reasonable quality and have reasonable guarantees of certainty. This is part of the basis for the idiom, buyer beware.
Ironically, there is no reciprocal danger of a market for a good product collapsing in this manner when the asymmetry is in favour of the buyer,[dubious ] that is to say, when the buyers can assess more accurately the quality of the products than the sellers. In this case, regular market forces of supply and demand will prevail, the sellers will get the highest price paid, and the trend will be to weed out products with prices in excess of their quality. This is likely the basis for the idiom that an informed consumer is a better consumer. An example of this might be the subjective quality of fine food and wines (beyond just safety and freshness issues). Individual consumers know best what they prefer to eat, and quality is almost always assessed in fine establishments by smell and taste before they pay. However, a definition of 'highest quality' for food and wine eludes providers. Thus, a large variety of better quality and higher priced restaurants are supported.
[edit] Used cars: a "lemons market"
Akerlof's paper uses the market for used cars as an example of the problem of quality uncertainty. There are good used cars and defective used cars ("lemons"). The buyer of a car does not know beforehand whether it is a good car or a lemon. So the buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of a car of known average quality.
This means that the owner of a good used car will be unable to get a high enough price to make selling that car worthwhile. Therefore, owners of good cars will not place their cars on the used car market. The withdrawal of good cars reduces the average quality of cars on the market, causing buyers to revise downward their expectations for any given car. This, in turn, motivates the owners of moderately good cars not to sell, and so on. The result is that a market in which there is asymmetrical information with respect to quality shows characteristics similar to those described by Gresham's Law: the bad drives out the good (although Gresham's Law applies to a different situation).
- Suppose we can use some number, q to index the quality of used cars, where q is uniformly distributed over the interval [0,1]. The average quality of a used car on the market is therefore 1/2.
- There are a large number of buyers looking for cars who are prepared to pay their reservation price of (3/2)q for a car that is of quality q. There are also a large number of sellers who are prepared to sell a car of quality q for the price q. If quality were observable, the price of used cars would therefore be somewhere between q and (3/2)q, and the cars would be sold and everyone would be perfectly happy.
- If the quality of cars is not observable by the buyers, then it seems reasonable for them to estimate the quality of a car offered to market using the average quality of all cars. Based on this estimation, the willingness to pay for any given car will therefore be (3/2)(q_avg), where q_avg is the average quality of all the cars.
- Now, assume that the equilibrium price in the market is some price, p, where p>0. At this price, all the owners of cars with quality less than p will want to offer their cars for sale. Since again, quality is uniformly distributed over the interval from 0 to this p, the average quality of the cars offered for sale at p will be worth only p/2.
- We know however that for an expected quality worth p/2, buyers will only be willing to pay (3/2)(p/2) = (3/4)p. Therefore we can conclude that no cars will be sold at p. Because p is any arbitrary positive price, it is shown that no cars will be sold at any positive price at all. The market for used cars collapses when there is asymmetric information. p
George E. Hoffer and Michael D. Pratt state that the “economic literature is divided on whether a lemons market actually exists in used vehicles." The authors’ research supports the hypothesis that “known defects provisions,” used by US states (e.g., Wisconsin) to regulate used car sales have been ineffectual, because the quality of used vehicles sold in these states is not significantly better than the vehicles in neighboring states without such consumer protection legislation.[1]
[edit] Criteria for a lemon market
A lemon market will be produced by the following:
- Asymmetry of information
- no buyers can accurately assess the value of a product through examination before sale is made
- all sellers can more accurately assess the value of a product prior to sale
- An incentive exists for the seller to pass off a low quality product as a higher quality one
- Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)
- Deficiency of effective public quality assurances (by reputation or regulation)
- Deficiency of effective guarantees / warranties
[edit] Other "lemons markets"
There are other markets where buyers face the problem of quality uncertainty and information asymmetry. In reality, no existing market can be accurately described as a complete lemon market, because if the above criteria were met entirely, the market would not exist. In reality, any market might exhibit a trend towards decreased quality and decreased sale value, due to the lemon market principle, if the consumer is less informed and empowered than the seller. Below are described some of the worst-case scenarios where markets fail to exist or have demonstrated extremely low quality products due to uncertainty.
[edit] Milk in India in the 1970s
In India in the 1970s, good quality, fresh milk was rarely available, because so many merchants watered down their milk to increase their profits. Since buyers could not assess the milk’s butterfat content, the low-quality milk drove out the high-quality milk. The Indian National Dairy Development Board provided machines to measure butterfat content and created brand names to build buyers' trust in the milk they were buying. As a result, the quality of milk available in India improved.[2]
[edit] Street Vendors in India
In many of India's cities, vendors sell their goods at traffic signals and on the pavement. Often vendors can be observed selling perishables like fruits. There is no guarantee about the quality of the fruit being bought and thus the buyer is always in a dilemma as a swift decision needs to be made. One way of checking on the quality is to use a price bargaining technique. We assume that the buyer is purchasing strawberries from the vendor. The buyer can select individual boxes of strawberries and bargain on the price. Boxes that the seller is ready to sell for lower prices than quoted earlier will most probably turn out to be the lemons. When tried out, this technique had a success rate of 68%. As this is an extremely simplified model, this technique is more difficult to apply when automobiles or other bigger lemon markets are taken into consideration as with choices, colours and models all needed to be factored into the decision making process of the seller, the model does tend to get distorted.
[edit] Memory Cards and MP3 Players on eBay
 |
The tone or style of this article or section may not be appropriate for Wikipedia. Specific concerns may be found on the talk page. See Wikipedia's guide to writing better articles for suggestions.(March 2008) |
It has become common for unscrupulous sellers on eBay to sell "hacked" memory cards and MP3 players that report to the operating system that more memory exists in the player than is actually available. Since there is generally no way for the buyer to know whether the player is hacked before attempting to copy files to it, non-hacked players are driven out of the market by less-expensive, hacked players. This scam tends to go unnoticed until after the customer leaves feedback because the fact that less memory than advertised is available will not be noticed until one attempts to copy files beyond the true size of the device and then to read them back. Therefore, the seller's feedback rating provides very little information as to the quality of the player in question.
There are a number of other obvious symptoms indicating that eBay is developing into a "Market for Lemons". Numerous luxury brands have sued eBay over the enormous problem of counterfeit goods on the site including Tiffany & Co.[3] and Louis Vuitton. On average, 90-95% of the Tiffany product on the site is counterfeit. Professional merchants have also developed major economic challenges on the marketplace such as GlacierBayDVD[4] (previously eBay's #1 rated merchant). PESA, a group of eBay's largest merchants, has declared that the economic health of the marketplace is suffering[5].
[edit] Lemon laws in the United States
The United States has a federal lemon law (the Magnuson-Moss Warranty Act) that protects citizens of all states. There are also state laws regarding lemons which vary by state and may not necessarily cover used or leased vehicles. The rights afforded to consumers by lemon laws may exceed the warranties expressed in purchase contracts. These state laws provide remedies to consumers for automobiles that repeatedly fail to meet certain standards of quality and performance. Lemon Law is the common nickname for these laws, but each state has different names for the laws and acts, which may also cover more than just automobiles. In California and federal law, "Lemon Laws" cover anything mechanical.
The federal lemon law also provides the warrantor may be obligated to pay your attorney fees if you prevail in a lemon law suit, as do most state lemon laws. If a car has to be repaired for the same defect four or more times and the problem is still occurring, the car may be deemed to be "a lemon." The defect must substantially hinder the vehicle's use, value or safety. Purchasers who knowingly purchase a car in "as is" condition accept the defects and void their rights under the lemon law.
[edit] Citation
- Akerlof, George A. (1970). "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism". Quarterly Journal of Economics 84 (3): 488–500. doi:.
[edit] References
- ^ Hoffer, George E.; Pratt, Michael D. (1987). "Used vehicles, lemons markets, and Used Car Rules: Some empirical evidence". Journal of Consumer Policy 10 (4): 409–414. doi:.
- ^ http://faculty-gsb.stanford.edu/mcmillan/personal_page/documents/Market%20Institutions.pdf.
- ^ Sullivan, Bob. "EBay fights its toughest legal battle", MSNBC, 2004-09-21.
- ^ Hof, Bob (2006-02-14). Buying Safely on eBay. BusinessWeek: The Tech Beat.
- ^ Unhealthy Marketplace Dynamics - Seller Perspective. Professional eBay Sellers Alliance (June 2007). Retrieved on 2008-06-03.
