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The Market for "Lemons": Quality Uncertainty and the Market Mechanism
George A. Akerlof
The Quarterly Journal of Economics, Vol. 84, No. 3. (Aug., 1970), pp. 488-500.
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T H E MARKET FOR "LEMONS": QUALITY UNCERTAINTY AND T H E
MARKET MECHANISM '
I. Introduction, 4 8 8 . ~ 1 1 .The model with automobiles as an example, 489.-111. Examples and applications, 492.-IV. Counteracting institutions, 499. -V. Conclusion, 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. On the other hand, this paper presents a strug- gling attempt t o give structure to the statement: "Business in under- developed countries is difficult"; in particular, a structure is given for determining the economic costs of dishonesty. Additional appli- cations of the theory include comments on the structure of money markets, on the notion of "insurability," on the liquidity of dur- a b l e ~ ,and on brand-name goods.
There are many markets in which buyers use some market statistic t o judge the quality of prospective purchases. I n 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 t o the individual seller. As a result there tends t o be a reduction in the average quality of goods and also in the size of the market. It should also be perceived that in these markets social and private returns differ, and therefore, in some cases, governmental intervention may increase the welfare of all parties. Or private institutions may arise to take advantage of the potential increases in welfare which can accrue to all parties. By nature, however, these institutions are nonatomistic, and there- fore concentrations of power -with ill consequences of their own – can develop.
The author would especially like to thank Thomas Rothenberg for invaluable comments and inspiration. In addition he is indebted to Roy Radner, Albert Fishlow, Bernard Saffran, William D. Nordhaus, Giorgio La Malfa, Charles C. Holt, John Letiche, and the referee for help and sugges- tions. He would also like to thank the Indian Statistical Institute and the Ford Foundation for financial support.
M A R K E T F O R " L E M O N S " : A N D M A R K E T M E C H A N I S M 489
The automobile market is used a s a finger exercise to illustrate and develop these thoughts. It should be emphasized that this mar- ket is chosen for its concreteness and ease in understanding rather than for its importance or realism.
A. The Automobiles Market The example of used cars captures the essence of the problem.
From time t o time one hears either mention of or surprise a t the large price difference between new cars and those which have just left the showroom. The usual lunch table justification for this phenomenon is the pure joy of owning a "new" car. 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.
The individuals in this market buy a new automobile without knowing whether the car they buy will be good or a lemon. But they do know that with probability q it is a good car and with probability (1-9) i t is a lemon; by assumption, q is the proportion of good cars produced and (1-q ) is the proportion of lemons.
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; i.e., the owner assigns a new probability to the event that his car is a lemon. This estimate is more accurate than the original estimate. 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 c a n and bad cars must still sell a t the same price- since i t is impossible for a buyer to tell the difference be- tween a good car and a bad car. It is apparent that a used car can- not have the same valuation as a new car -if i t did have the same valuation, i t would clearly be advantageous to trade a lemon a t the price of new car, and buy another new car, a t a higher prob- ability q of being good and a lower probability of being bad. Thus the owner of a good machine must be locked in. Not only is i t true that he cannot receive the true value of his car, but he cannot even obtain the expected value of a new 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
490 QUARTERLY JOURNAL OF ECONOMICS
same way t h a t 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 a t the same price as good c a n ; similarly, bad money drives out good because the exchange rate is even. But the bad cars sell a t the same price a s good cars since i t is impossible for a buyer t o tell the difference between a good and a bad car; only the seller knows. I n 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.
B . Asymmetrical Information
It has been seen that the good cars may be driven out of the market by the lemons. But in a more continuous case with different grades of goods, even worse pathologies can exist. For i t is quite possible to have the bad driving out the not-so-bad driving out the medium driving out the not-so-good driving out the good in such a sequence of events that no market exists a t all.
One can assume t h a t the demand for used automobiles depends most strongly upon two variables -the price of the automobile p and the average quality of used cars traded, p, or Q d = D (p, p). Both the supply of used cars and also the average quality p will depend upon the price, or p = p (p) and S= S(p) . And in equilibrium the supply must equal the demand for the given average quality, or S ( p ) = D ( p , p ( p ) ) . As the price falls, normally the quality will also fall. And i t is quite possible t h a t no goods will be traded at any price level.
Such an example can be derived from utility theory. Assume t h a t there are just two groups of traders: groups one and two. Give group one a utility function
U l = M + 2 ~4 i- 1
where M is the consumption of goods other than automobiles, x, is the quality of the ith automobile, and n is the number of auto- mobiles.
Similarly, let n
U2 = M + S 3 / 2 ~ 4 i-1
where M, xi,and n are defined a s before. Three comments should be made about these utility func-
tions: (1) without linear utility (say with logarithmic utility) one geta needlessly mired in algebraic complication. (2) The use of
M A R K E T F O R " L E M O N S " : A N D M A R K E T M E C H A N I S M 491
linear utility allows a focus on the effects of asymmetry of informa- tion; with a concave utility function we would have t o deal jointly with the usual risk-variance effects of uncertainty and the special effects we wish t o discuss here. (3) U1 and U2 have the odd char- acteristic t h a t the addition of a second car, or indeed a kth car, adds the same amount of utility a s the first. Again realism is sacri- ficed to avoid a diversion from the proper focus.
To continue, it is assumed (1) that both type one traders and type two traders are von Neumann-Morgenstern maximizers of expected utility; (2) that group one has N cars with uniformly distributed quality x, 0 5 x 5 2 , and group two has no cars; (3) that the price of "other goods" M is unity.
Denote the income (including that derived from the sale of automobiles) of all type one traders a s Y1 and the income of all type two traders as Y2. The demand for used cars will be the sum of the demands by both groups. When one ignores indivisibilities, the demand for automobiles by type one traders will be
D l = Y ~ / P P/P > 1 D l = O P/P < 1.
And the supply of cars offered by type one traders is
(1) S ~ = P N / ~ p 5 2 with average quality
(2) p = P/2.
(To derive (1) and ( 2 ) , the uniform distribution of automobile quality is used.)
Similarly the demand of type two traders is
D2 = Y ~ / P 3 ~ / 2>P D2 = O 3 ~ / 2<P
and s, =0.
Thus total demand D (p, P) is
D ( P , P) = ( Y P + ~ I ) / P if p < p D (P, P) = Y ~ / P if ~ < p < 3 p / 2
D(P, P) = o if p > 3 ~ / 2 . However, with price p, average quality is p/2 and therefore a t no price will any trade take place a t all: in spite of the fact that at any given price between 0 and 3 there are traders of type one who are willing to sell their automobiles a t a price which traders of type two are willing t o pay.
492 Q U A R T E R L Y J O U R N A L OF E C O N O M I C S
C. Symmetric Information The foregoing is contrasted with the case of symmetric infor-
mation. Suppose that the quality of all cars is uniformly distributed, 0 5 x 5 2 . Then the demand curves and supply curves can be written a s follows:
Supply S(P)= N P > 1 S ( P ) = o p < l .
And the demand curves are
D ( P ) = ( Y P + ~ I ) / P p < l D ( P ) = (Y2/p) 1 < p < 3 / 2 D ( P ) = 0 p >3/2.
I n equilibrium
(3) P = l if Y 2 < N (4) P = Y2/N if 2Y2/3 <N < Y2 (5) P =3/2 if N<2Y2/3. If N < Y2 there is a gain in utility over the case of asymmetrical information of N/2. (If N > Y2, in which case the income of type two traders is insufficient t o buy all N automobiles, there is a gain in utility of Y2/2 units.)
Finally, it should be mentioned that in this example, if traders of groups one and two have the same probabilistic estimates about the quality of individual automobiles -though these estimates may vary from automobile t o automobile – (3)' (4)' and (5) will still describe equilibrium with one slight change: p will then represent the expected price of one quality unit.
A . Insurance It is a well-known fact that people over 65 have great difficulty
in buying medical insurance. The natural question arises: why doesn't the price rise t o match the risk?
Our answer is that as the price level rises the people who in- sure themselves will be those who are increasingly certain that they will need the insurance; for error in medical check-ups, doctors' sympathy with older patients, and so on make it much easier for the applicant t o assess the risks involved than the insurance com- pany. The result is that the average medical condition of insurance applicants deteriorates as the price level rises- with the result
M A R K E T F O R " L E M O N S " : A N D M A R K E T 1 M E C H A N I S J f 493
that no insurance sales may take place a t any price.l This is strictly analogous to our automobiles case, where the average quality of used cars supplied fell with a corresponding fall in the price level. This agrees with the explanation in insurance textbooks:
Generally speaking policies are not available a t ages materially greater than sixty-five. . . . The term prcmiums are too high for any but the most pessimistic (which is to say the least healthy) insureds to find attractive. Thus there is a severe problem of adverse selection a t these ages.'
The statistics do not contradict this conclusion. While de- mands for health insurance rise with age, a 1956 national sample survey of 2,809 families with 8,898 persons shows that hospital insurance coverage drops from 63 per cent of those aged 45 t o 54, to 31 per cent for those over 65. And surprisingly, this survey also finds average medical expenses for males aged 55 to 64 of $88, while males over 65 pay an average of $77.3 While noninsured ex- penditure rises from $66 t o $80 in these age groups, insured expcn- diture declines from $105 t o $70. The conclusion is ternpting t h a t insurance companies are particularly wary of giving medical in- surance t o older people.
The principle of "adverse selection" is potentially present in all lines of insurance. The following statement appears in an in- surance textbook written a t the Wharton School:
There is potential adverse selection in the fact that healthy term in- surance policy holders may decide to terminate their coverage when they be- come older and premiums mount. This action could leave an insurer with an undue proportion of below average risks and claims might be higher than anticipated. Adverse selection "appears (or a t least is possible) whenever the individual or group insured has freedom to buy or not to buy, to choose the amount or plan of insurance, and to persist or to discontinue as a policy holder." '
Group insurance, which is the most common form of medical insurance in the United States, picks out the healthy, for generally
1. Arrow's fine article, "Uncertainty and Medical Care" ( A m e r i c a n Eco- nomic Review,Vol. 53, 1963), does not make this point explicitly. He em- phasizes "moral hazard" rather than "adverse selection." I n it,s strict sense, the presence of "moral hazard" is equally disadvantageous for both govern- mental and private programs; in its broader sense, which includes "adverse selection," "moral hazard" gives a decided advantage to government insurance programs.
2. 0. D. Dickerson. H e a l t h Insurance (Homewood. Ill.: Irwin. 1959). p. 333.
3. 0. W. Anderson (with J. 6 . Feldman), F a m i l y Medical Costs and I n – surance (New York: McGraw-Hill, 1956).
4. H. S. Denenberg, R. D. Eilers, G. W. Hoffman, C. A . Kline, J. J. Melone, and H. W. Snider, Risk and Insurance (Englewood Cliffs, N . J.: Prentice Hall, 19641, p. 446.
494 Q U A R T E R L Y J O U R N A L OF E C O N O M I C S
adequate health is a precondition for employment. At the same time this means t h a t medical insurance is least available to those who need i t most, for the insurance companies do their own "ad- verse selection."
This adds one major argument in favor of m e d i ~ a r e . ~ On a cost benefit basis medicare may pay off: for i t is quite possible that every individual in the market would be willing to pay the ex- pected cost of his medicare and buy insurance, yet no insurance company can afford to sell him a policy -for a t any price i t will attract too many "lemons." The welfare economics of medicare, in this view, is exactly analogous to the usual classroom argument for public expenditure on roads.
B. The Employment of Minorities
The Lemons Principle also casts light on the employment of minorities. Employers may refuse to hire members of minority groups for certain types of jobs. This decision may not reflect ir- rationality or prejudice -but profit maximization. For race may serve a s a good statistic for the applicant's social background, quality of schooling, and general job capabilities.
Good quality schooling could serve a s a substitute for this statistic; by grading students the schooling system can give a better indicator of quality than other more superficial character- istics. As T . W. Schultz writes, "The educational establishment discovers and cultivates potential talent. The capabilities of chil- dren and mature students can never be known until foundand culti- vated." (Italics added.) An untrained worker may have valuable natural talents, but these talents must be certified by "the educa- tional establishment" before a company can afford to use them. The certifying establishment, however, must be credible; the unrelia- bility of slum schools decreases the economic possibilities of their students.
This lack may be particularly disadvantageous to members of
5. The following quote, again taken from an insurance textbook, shows how far the medical insurance market is from perfect competition:
. . . insurance companies must screen their ap licants. Naturally it is t:e that many people will voluntarily seek ajequate insurance on their own initiative. But in such lines as accident and health insurance, companies are likely to give a second look to persons who voluntarily seek insurance without being approached by an agent." (F. J. Angell, Insur- ance, Principles and Practices, New York: The Ronald Press, 1957, pp. a9.)
This shows that insurance is not a commodity for sale on the open market. 6. T . W. Schultz, The Economic Value of Education (New York: Colum-
bia University Press, 1964), p. 42.
M A R K E T FOR " L E M O N S ' : A N D M A R K E T M E C H A N I S M 495
already disadvantaged minority groups. For an employer may make a rational decision not to hire any members of these groups in responsible positions -because it is difficult to distinguish those with good job qualifications from those with bad qualifications. This type of decision is clearly what George Stigler had in mind when he wrote, "in a regime of ignorance Enrico Fermi would have been a gardener, Von Neumann a checkout clerk a t a drugstore."
As a result, however, the rewards for work in slum schools tend to accrue to the group as a whole-in raising its average quality -rather than to the individual. Only insofar as informa- tion in addition to race is used is there any incentive for training.
An additional worry is that the Office of Economic Opportunity is going t o use cost-benefit analysis t o evaluate its programs. For many benefits may be external. The benefit from training minority groups may arise as much from raising the average quality of the group as from raising the quality of the individual trainee; and, likewise, the returns may be distributed over the whole group rather than to the individual.
C . T h e Costs o f Dishonesty
The Lemons model can be used t o make some comments on the costs of dishonesty. Consider a market in which goods are sold honestly or dishonestly; quality may be represented, or it may be misrepresented. 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 -a s 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. There may be potential buyers of good quality products and there may be po- tential sellers of such products in the appropriate price range; however, the presence of people who wish to pawn bad wares as good wares tends t o drive out the legitimate business. 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.
Dishonesty in business is a serious problem in underdeveloped countries. Our model gives a possible structure to this statement and delineates the nature of the "external" economies involved. In particular, in the model economy described, dishonesty, or the
7. G. J. Stigler, "Infomation and the Labor Market," Journal of Polili- url Economy, Vol. 70 (Oct. 1962), Supplement, p. 104.
496 QUARTERLY JOURNAL OF ECONOMICS
misrepresentation of the quality of automobiles, costs 1/2 unit of utility per automobile; furthermore, it reduces the size of the used car market from N to 0. IVe can, consequently, directly evaluate the costs of dishonesty -a t least in theory.
There is considerable evidence that quality variation is greater in underdeveloped than in developed areas. For instance, the need for quality control of exports and State Trading Corporations can be taken as one indicator. I n India, for example, under the Export Quality Control and Inspection Act of 1963, "about 85 per cent of Indian exports are covered under one or the other type of quality control." Indian housewives must carefully glean the rice of the local bazaar to sort out stones of the same color and shape which have been intentionally added t o the rice. Any comparison of the heterogeneity of quality in the street market and the canned qual- ities of the American supermarket suggests that quality variation is a greater problem in the East than in the West.
I n one traditional pattern of development the merchants of the pre-industrial generation turn into the first entrepreneurs of the next. The best-documented case is Japan: but this also may have been the pattern for Britain and America.' I n our picture the im- portant skill of the merchant is identifying the quality of merchan- dise; those who can identify used cars in our example and can guarantee the quality may profit by as much as the difference be- tween type two traders' buying price and type one traders' selling price. These people are the merchants. I n production these skills are equally necessary -both t o be able to identify the quality of inputs and to certify the quality of outputs. And this is one (added) reason why the merchants may logically become the first entrepren- eurs.
The problem, of course, is that entrepreneurship may be a scarce resource; no development text leaves entrepreneurship un- emphasized. Some treat i t as centraL2 Given, then, that entrepre- neurship is scarce, there are two ways in which product variations impede development. First, the pay-off t o trade is great for would- be entrepreneurs, and hence they are diverted from production; second, the amount of entrepreneurial time per unit output is greater, the greater are the quality variations.
8. T h e Times o f India, Nov. 10, 1967, p. 1. 9. See M . J . Levy, Jr., "Contrasting Factors in the Modernization of
China and Japan," in Economic Growth: Brazil, India, Japan, ed. S. Kuznets, e t . al. (Durham, N. C.: Duke University Press, 1955).
1. C. P. Kindleberger, Economic Development (New York: McGraw- Hill, 19581, p. 86.
2. For example, see W. Arthur Lewis, The Theory of Economic Growth (Homewood, 111.: Irwin, 19551, p. 196.
M A R K E T FOR "LEMONS": A N D M A R K E T M E C H A N I S M 497
D. Credit Markets in Underdeveloped Countries
(1) Credit markets in underdeveloped countries often strongly reflect the operation of the Lemons Principle. I n India a major fraction of industrial enterprise is controlled by managing agencies (according to a recent survey, these "managing agencies" controlled 65.7 per cent of the net worth of public limited companies and 66 per cent of total assets) .3 Here is a historian's account of the func- tion and genesis of the ((managing agency system":
The management of the South Asian commercial scene remained the function of merchant houses, and a type of organization peculiar to South Asia known as the Managing Agency. When a new venture was promoted (such as a manufacturing plant, a plantation, or a trading venture), the pro- moters would approach an established managing agency. The promoters might be Indian or British, and they might have technical or financial re- sources or merely a concession. In any case they would turn to the agency because of its reputation, which would encourage confidence in the venture and stimulate investment?
I n turn, a second major feature of the Indian industrial scene has been the dominance of these managing agencies by caste (or, more accurately, communal) groups. Thus firms can usually be classified according to communal o r i g i n . V n this environment, in which outside investors are likely to be bilked of their holdings, either ( I ) firms establish a reputation for ('honest" dealing, which confers upon them a monopoly rent insofar as their services are
3. Report of the Committee o n the Distribution of Income and Levels of Living, Part I, Government of India, Planning Commission, Feb. 1964, p. 44–.
4. H. Tinker, South Asia: A Short History (New York: Praeger, 1966), p. 134.
5. T h e existence of the following table (and also the small per cent of firms under mixed control) indicates the communalization of the control of firms. Source: M. M. Mehta, Structure o f Indian Industries (Bombay: Popular Book Depot, 19551, p. 314.
DISTRIBUTIONO F INDUSTRIAL BYCONTROL COMMUNITY 1911 1931 1951
(number of firms) British 281 416 382 Parsis 15 25 19 Gujratis 3 11 17 Jews 5 9 3 Muslims – 10 3 Bengalis 8 5 20 Marwaris – 6 96 Mixed control -28 -28 -79
Total 341 510 619
Also, for the cotton industry see H. Fukuzawa, "Cotton Mill Industry," in V. B. Singh, editor, Economic History of India, 1867-1966 (Bombay: Allied Publishers, 1965).
498 Q U A R T E R L Y J O U R N A L OF ECONOMICS
limited in supply, or (2) the sources of finance are limited to local communal groups which can use communal -and possibly famil- ial -ties to encourage honest dealing within the community. It is, in Indian economic history, extraordinarily difficult to discern whether the savings of rich landlords failed to be invested in the industrial sector (1) because of a fear to invest in ventures con- trolled by other communities, (2) because of inflated propensities to consume, or (3) because of low rates of r e t ~ r n . ~ At the very least, however, i t is clear that the British-owned managing agencies tended t o have an equity holding whose communal origin was more hetero- geneous than the Indian-controlled agency houses, and would usually include both Indian and British investors.
(2) A second example of the workings of the Lemons Principle concerns the extortionate rates which the local moneylender charges his clients. I n India these high rates of interest have been the lead- ing factor in landlessness; the so-called "Cooperative Movement" was meant t o counteract this growing landlessness by setting up banks t o compete with the local moneylender^.^ While the large banks in the central cities have prime interest rates of 6, 8, and 10 per cent, the local moneylender charges 15, 25, and even 50 per cent. The answer to this seeming paradox is that credit is
6. For the mixed record of industrial profits, see D. H. Buchanan, The Development of Capitalist Enterprise in India (New York: Kelley, 1966, reprinted).
7. The leading authority on this is Sir Malcolm Darling. See his Punjabi Peasant i n Prosperity and Debt. The following table may also prove instruc- tive :
Commonest rates for – Secured loam Unsecured loans Grain loans
(per cent) (per cent) (per cent) Punj ab
6 to 12 12 to 24 (18 3/4 commonest)
Bihar Orissa 25 Bengal 9 to 18 for "respectable clients"
18 Yi to 37 7 (the latter com- mon to agriculturalists)
Central 15 for proprietors Provinces 24 for occupancy tenants
37 7 for ryots with no right of transfer
Bombay 9 to 12 12 to 25 (18 commonest) Sind 36 Madras 12 15 to 18 (in insecure tracts 24 20 to 50
Source: Puniabi Peasant in Prosperity and Debt, 3rd ed. (Oxford University Press, 1932), p. 190.
M A R K E T FOR "LEMONS": A N D M A R K E T M E C f i A N I S M 499
granted only where the granter has (1) easy means of enforcing his contract or ( 2 ) personal knowledge of the …
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