The Market for Lemons

lemon law

The Market for Lemons: Quality Uncertainty and the Market Mechanism is a well-known 1970 paper by American economist George Akerlof which examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only ‘lemons’ behind (cars or other products that are found to be defective only after they have been bought).

Akerlof’s paper shows how prices can determine the quality of goods traded on the market. Low prices drive away sellers of high-quality goods, leaving only lemons behind. In 2001, Akerlof, along with Michael Spence, and Joseph Stiglitz, jointly received the Nobel Memorial Prize in Economic Sciences, for their research on issues related to asymmetric information.

Akerlof’s paper uses the market for used cars as an example of the problem of quality uncertainty. A used car is one in which ownership is transferred from one person to another, after a period of use by its first owner and its inevitable wear and tear. There are good used cars (‘peaches’) and defective used cars (‘lemons’), normally as a consequence of several not-always-traceable variables, such as the owner’s driving style, quality and frequency of maintenance, and accident history.

Because many important mechanical parts and other elements are hidden from view and not easily accessible for inspection, the buyer of a car does not know beforehand whether it is a peach 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 carefully maintained, never-abused, 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 asymmetric information with respect to quality shows characteristics similar to those described by Gresham’s Law: the bad drives out the good. (Although Gresham’s principle applies more specifically to exchange rates, modified analogies can be drawn.)

Thus the uninformed buyer’s price creates an adverse selection problem, where the side of an information asymmetry with more information takes advantage of the party with less. When uncontrolled, adverse selection is a market mechanism that can lead to a market collapse. According to Akerolof: ‘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.’

As a consequence of the mechanism described in this paper, markets may fail to exist altogether in certain situations involving quality uncertainty. Examples given in Akerlof’s paper include the market for used cars, the dearth of formal credit markets in developing countries, and the difficulties that the elderly encounter in buying health insurance. 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.’

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 wine. 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. That is, if a customer in a fine establishment orders a lobster and the meat is not fresh, he can send the lobster back to the kitchen and refuse to pay for it. However, a definition of ‘highest quality’ for food eludes providers. Thus, a large variety of better-quality and higher-priced restaurants are supported.

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.

Both the ‘American Economic Review’ and the ‘Review of Economic Studies’ rejected the paper for ‘triviality,’ while the reviewers for ‘Journal of Political Economy’ rejected it as incorrect, arguing that, if this paper were correct, then no goods could be traded. Only on the fourth attempt did the paper get published in ‘Quarterly Journal of Economics.’ Today, the paper is one of the most-cited papers in modern economic theory and most downloaded economic journal paper of all time. It has profoundly influenced virtually every field of economics, from industrial organization and public finance to macroeconomics and contract theory.

Libertarians, like William L. Anderson, oppose the regulatory approach proposed by the authors of the paper, observing that some used-car markets haven’t broken down even without lemon legislation and that the lemon problem creates entrepreneurial opportunities for alternative marketplaces or customers’ knowledgeable friends.

Five years after Akerlof’s paper was published, the United States enacted 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 that the warrantor may be obligated to pay the attorney fees of the party prevailing 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.’

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.