Why lemons don’t always make lemonade: The importance of information asymmetry

Think about the first major economic transaction that most people face: buying your first car. Being an attentive consumer, you had to carefully consider numerous details from safety features to fuel efficiency and so on. Yet, being limited to the second-hand market meant one factor was more important than any other, the condition of the vehicle. If one thing was certain, you didn’t want your first car to be lemon.

Assuming that you aren’t a mechanic, the seller of a used car will know more about the good’s condition than the buyer; that means that they are in an advantageous position. In economics terms, this is due to what is known as information asymmetry. Economist George A. Akerlof considered the problem of information asymmetry to be very important to the field of economics. In the 1960s, the general school of thought in the economic community largely lent on the single model of perfect competition.[1] This model relied on the assumption that, more often than not, perfect information was available to both participants of a transaction and that information asymmetry wasn’t of any significant concern.

In order to demonstrate the short comings of the perfect competition model, Akerlof wrote the now-influential article, The Market for ‘Lemons’. Akerlof used the second-hand car market to show that without institutions, certain markets can experience degradation and eventually complete failure. In the used car market, sellers of ‘lemons’ (cars in bad condition) are at an advantage; only they know that their car is a lemon. Because a buyer must assume that some cars are lemons- but cannot distinguish between a lemon and a ‘peach’ (the immaculate high-quality cars)- the buyer will be forced to factor in the probability of buying a lemon, lowering the maximum price they are willing to offer. Consequently, the sellers of ‘peaches’ are deprived of any appropriate offers for their pristine cars and this drives the sellers of peaches out of the market. In turn, the quality of goods in the market will degrade, causing the cycle to repeat until the point in which only the ‘lemons’ remain.

The Market for ‘Lemons’ was concerned with three concepts: information asymmetry, the role of institutions in market efficiency and the link between microeconomics and macroeconomics. Firstly, Akerlof demonstrated that asymmetric information – if concerning a fundamental factor – could lead to complete market failure, questioning the assumption that free markets always lead to mutually beneficial outcomes. Secondly, Akerlof produced a convincing argument for the incorporation of strong institutions in an economy. In order to preserve market efficiency and protect the needs of both sellers and buyers, some sort of mechanism was necessary – think pre-purchase checks or consumer protection regulation.[2] Lastly, Akerlof’s findings raised an important question: if asymmetric information could lead to market failure and the market in question were large enough, could that market’s failure affect the entire economy? (Hint: Arkerlof thinks yes).

Like many before him, Akerlof’s ideas were considered to be provocative. After receiving his Ph.D. from MIT in 1966, Arkerlof got to work trying to tackle the problem of introducing information asymmetry to the perfect competition model. Akerlof started by considering the inefficiency of the “egg-grader” model of education (I have an economics degree, you have an economics degree, but are we equally educated?) before progressing to the used automobile market. In 1967, Akerlof submitted his paper to The American Economic Review, it was rejected for being too trivial. Akerlof tried again, this time The Review of Economics Studies, he received the same response. The third rejection was perhaps the most intriguing. The Journal of Political Economy responded by declaring that if he were correct, no used cars would ever be sold, so he must be wrong.[3] It was a case of fourth time lucky for Akerlof as in 1970 his paper was published in the Quarterly Journal of Economics.

There is an important lesson to be learned from the lemon story. The first three journal editors were bogged down by the literal details of Akerlof’s theory. An astute economist should avoid this at all costs, although many can’t. This being said, since being published many people have used Akerlof’s theory to explore the implications of information asymmetry in the economy. Akerlof’s work played a central role in inspiring the well-regarded work of Michael Spence and Joseph Stiglitz, two economists with whom he shared a Nobel Prize in Economics in 2001. More importantly, his theory has also inspired successive economists to question the assumptions of traditional economic models. As a result, his ideas have played an important role in the development of economic thought into the more comprehensive field it is today.

Not surprisingly, some critics have continued to test and challenge the ‘lemon’ theory. Hoffner and Pratt, declare that “known defects provision” laws found in some U.S. states are ineffectual at creating better quality second-hand car markets.[4] For Akerlof and co., however, the economic debate has progressed and more advanced economic questions are demanding their attention. The foremost of these surfaced in the aftermath of the latest global financial crisis. Something about the GFC sounds familiar: a worldwide economic crisis brought on by the dissemination of toxic debt deemed to be safe by an unreliable credit rating system or maybe it’s the financial market failure that followed. If one thing is assured, the lemon theory reminds us that we are all susceptible to the risks posed by asymmetric information. I have no doubt that The Market for Lemons will remain significant to economic discussion for years to come.

[1] http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2001/akerlof-article.html

[2] http://www.econlib.org/library/Enc/bios/Akerlof.html

[3] http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2001/akerlof-article.html

[4] Hoffer, George E., and Michael D. Pratt. 1987. “Used Vehicles, Lemons Markets, And Used Car Rules: Some Empirical Evidence”. J Consum Policy 10 (4): 409-414.