Quality Uncertainty and the Market for Lemons

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Suppose you bought a new car for $10,000, drove it 100 miles, and then decided you really didn't want it. There was nothing wrong with the car-it performed beautifully and met all your expectations. You simply felt that you could do just as well without it and would be better off saving the money for other things. So you decide to sell the car. How much should you expect to get for it? Probably not more than $8000-even though the car is brand new, has been driven only 100 miles, and has a warranty that is transferable to a new owner. And if you were a prospective buyer, you probably wouldn't pay much more than $8000 yourself.

Why does the mere fact that the car is second hand reduce its value so much? To answer this question, think about your own concerns as a prospective buyer. Why, you would wonder, is this car for sale? Did the owner really change his or her mind about the car just like that, or is there something wrong with it? Perhaps this car is a 'Temon."

Used cars sell for much less than new cars because there is asymmetric information about their quality: The seller of a used car knows much more about the car than the prospective buyer does. The buyer can hire a mechanic to check the car, but the seller has had experience with it, and will know more about it. Furthermore, the very fact that the car is for sale indicates that it may be a "lemon"-why sell a reliable car? As a result, the prospective buyer of a used car will always be suspicious of its quality-and with good reason.

The implications of asymmetric information about product quality were first analyzed by George Akerlof in a classic paper.1 Akerlof s analysis goes far beyond the market for used cars. The markets for insurance, financial credit, and even employment are also characterized by asymmetric quality information. To understand its implications, we will start with the market for used cars and then see how the same principles apply to other markets.

The Market for Used Cars

Suppose two kinds of used cars are available-high-quality cars and low-quality cars. Also, suppose that both sellers and buyers can tell which kind of car is

1 George A. Akerlof, The Market for "Lemons': Quality Uncertainty and the Market Mechanism," Quarterly Journal of Economics (Aug. 1970): 488-500.

which. There will then be two markets, as illustrated in Figures 17.1a and 17.1b. In Figure 17.1a, Sh is the supply curve for high-quality cars, and Dh is the demand curve. Similarly, Sl and Dl in Figure 17.1b are the supply and demand curves for low-quality cars. Note that Sh is higher than Sibecause owners of high-quality cars are more reluctant to part with them and must receive a higher price to do so. Similarly, Dh is higher than Dl because buyers are willing to pay more to get a high-quality car. As the figure shows, the market price for high-quality cars is $10,000, for low-quality cars $5000, and 50,000 cars of each type are sold.

In reality, the seller of a used car knows much more about its quality than a buyer does. Consider what happens, then, if sellers'know the quality of cars, but buyers do not. (Buyers discover the quality only after they buy a car and drive it for a while.) Initially, buyers might think that the odds are 50-50 that a car they buy will be high quality. (The reason is that when both sellers and buyers knew the quality, 50,000 cars of each type were sold.) When making a

FIGURE 17.1 The Lemons Problem. When sellers of products have better information about product quality than buyers, a lemons market may develop in which low-quality goods drive out high-quality goods. In (a) the demand curve for high-quality cars shifts from Dh to Dm as buyers lower their expectations about the average quality of cars on the market. Likewise, in (b) the demand curve for low-quality cars shifts from Dl to DM- As a result,, the quantity of high-quality cars sold falls from 50,000 to 25,000, and the quantity of low-quality cars increases from 50,000 to 75,000. Eventually, only low-quality cars are sold.

FIGURE 17.1 The Lemons Problem. When sellers of products have better information about product quality than buyers, a lemons market may develop in which low-quality goods drive out high-quality goods. In (a) the demand curve for high-quality cars shifts from Dh to Dm as buyers lower their expectations about the average quality of cars on the market. Likewise, in (b) the demand curve for low-quality cars shifts from Dl to DM- As a result,, the quantity of high-quality cars sold falls from 50,000 to 25,000, and the quantity of low-quality cars increases from 50,000 to 75,000. Eventually, only low-quality cars are sold.

purchase, buyers would therefore view all cars as being of "medium" quality. (Of course, after buying the car, they will learn its true quality.) The demand for medium-quality cars, denoted by DM in Figure 17.1, is below Dh but above Dl. As the figure shows, fewer high-quality cars (25,000) and more low-quality cars (75,000) mill now be sold.

As consumers begin to realize that most cars sold (about three-fourths of the total) are low quality, their demands shift. As Figure 17.1 shows,, the new demand curve might be Dlm, which means that on average cars are of low to medium quality. However, the mix of cars then shifts even more heavily to low quality. As a result, the demand curve shifts further to the left, pushing the mix of cars even further to low quality. This shifting continues until only low-quality cars are sold. At that point the market price would be too low to bring forth any high-quality cars for sale, so consumers correctly assume that any car they buy will be low quality, and the demand curve will be Dl.

The situation in Figure 17.1 is extreme. The market may come into equilibrium at a price that brings forth at least some high-quality cars. But the fraction of high-quality cars will be smaller than it would be if consumers could identify quality before making the purchase. That is why I should expect to sell my brand new car, which 1 know is in perfect condition, for much less than I paid for it. Because of asymmetric information, low-quality goods drive high-quality goods out of the market.

Implications of Asymmetric Information

Our used cars example shows how asymmetric information can result in market failure. In an ideal world of fully functioning markets, consumers would be able to choose between low-quality and high-quality cars. Some would choose low-quality cars because they cost less, while others would prefer to pay more forhigh-quality cars. Unfortunately, consumers cannot in fact easily determine the quality of a used car until after they purchase it, so the price of used cars falls, and high-quality cars are driven out of the market.

Used cars are just a stylized example to illustrate an important problem that affects many markets. Let's look at other examples of asymmetric information, and then see how the government or private firms might react to it.

Insurance

Why do people over age 65 have difficulty buying medical insurance at almost any price? Older people do have a much higher risk of serious illness, but why doesn't the price of insurance rise to reflect that higher risk? The reason is asymmetric information. People who buy insurance know much more about their general health than any insurance company can hope to know, even if it insists on a medical examination. As a result, there is adverse selection, much as with used cars. Because unhealthy people are more likely to want insur ance, the proportion of unhealthy people in the pool of insured people increases. This forces the price of insurance to rise, so that more healthy people, realizing their low risks, elect not to be insured. This further increases the proportion of unhealthy people, which forces the price of insurance up more, and so on, until nearly all people who want to buy insurance are unhealthy. At that point selling insurance becomes unprofitable.

Adverse selection can make the operation of insurance markets problematic in other ways. Suppose an insurance company wants to offer a policy for a particular event, such, as an auto accident that results in property damage. It selects a target population-say, men under age 25-to whom it plans to market this policy, and it estimates the frequency of accidents within this group. For some of these people, the probability of being in an accident is low, much less than .01; for others it is high, much more than .01. If the insurance company cannot distinguish between high- and low-risk men, it will base the premium for all men on the average experience, i.e., an accident probability of .01. With better information some people(those with low probabilities of an accident) will choose not to insure, while others (those with high probabilities of an accident) will purchase the insurance. This in turn raises the accident probability of those who are insured above .01, forcing the insurance company to raise its premium. In the extreme, only those who are likely to suffer a loss will choose to insure, making it impractical to sell insurance.

These-kinds of market failure create a role for government. For health insurance, it provides an argument in favor of Medicare or related forms of government health insurance for the elderly. By providing insurance for all people over age 65, the government eliminates the problem of adverse selection.2

The Market for Credit

By using a credit card, many of us borrow money without providing any collateral. Most credit cards allow the holder to run a debit of several thousand dollars, and many people hold several credit cards. Credit card companies earn money by charging interest on the debit balance. But how can a credit card company or bank distinguish high-quality borrowers (who pay their debts) from low-quality borrowers (who don't)? Clearly,borrowers know more about whether they will pay than the company does. Again, the "lemons" problem arises. Credit card companies and banks must charge the same interest rate to all borrowers, which attracts more low-quality borrowers, which forces the interest rate up, which increases the number of low-quality borrowers, which forces the interest rate up further, and so on.

In fact, credit card companies and banks can, to some extent, use computerized credit histories, which they often share with one an other, to distinguish "low-quality" from "high-quality" borrowers. Many people think that com-

The same general argument applies to all age groups. That is one reason that insurance companies avoid adverse selection by offering group health insurance policies at places of employment.

puterized credit histories are an invasion of privacy. Should companies be allowed to keep these credit histories and share them with other companies? We can't answer this question for you, but we can point out that credit histories perform an important function. They eliminate, or at least greatly reduce, the problem of asymmetric information and adverse selection, which might otherwise prevent credit markets from operating. Without these histories, even the creditworthy would find it extremely costly to borrow money.

The Importance of Reputation and Standardization

Asymmetric information is also present in many other markets. Here are just a few examples: retail stores (Will the store repair or allow you to return a defective product? The store knows more about its policy than you do.); dealers of rare stamps, coins, books, and paintings (Are the items real or counterfeit? The dealer knows much more about their authenticity than you do.); roofers, plumbers, and electricians (When a roofer repairs or renovates the roof of your house, do you climb up to check the quality of the work?); restaurants (How often do you go into the kitchen to check if the chef is using fresh ingredients and obeying the health laws?).

In all these cases, the seller knows much more about the quality of the product than the buyer does. Unless sellers can provide information about quality to buyers, low-quality goods and services will drive out high-quality ones, and there will be market failure. Sellers of high-quality goods and services, therefore, have a big incentive to convince consumers that their quality is indeed high. In the examples cited above, this is done largely by reputation. You shop at a particular store because it has a reputation for servicing its products; you hire a particular roofer and plumber because they have a reputation for doing good work; and you go to a particular restaurant because it has a reputation for using fresh ingredients, and nobody you know became sick after eating there.

Sometimes it is impossible for a business to develop a reputation. For example, most of the customers of a diner or a motel on a highway go there only once, or infrequently, while on a trip, so that the business has no opportunity to develop a reputation. How, then, can these diners and motels deal with the "lemons" problem? One way is by standardization. In your hometown, you may not prefer to eat regularly at McDonald's. But a McDonald's may look more attractive when you are driving along a highway and want to stop for lunch. The reason is that McDonak's provides a standardized product; the same ingredients are used and the same food is served in every McDonald's anywhere in the country. Who knows? Joe's Diner might serve better food,but you know exactly what you will be buying at McDonak's.

EXAMPLE 17.1 LEMONS IN MAJOR LEAGUE BASEBALL

How can we test for the presence of a lemons market? One way is to compare the performance of products that are resold with similar products that are seldom put up for resale. In a lemons market, purchasers of second-hand products will have limited information, and resold products should be lower in quality than products that rarely appear on the market One such "second" hand" market has been created in recent years by a change in the rules governing contracts in major league baseball.3

Before 1976, major league baseball teams had the exclusive right to renew their players' contracts. After a 1976 ruling declared this system illegal, a new contracting arrangement was created. After six years of major league service, players can now sign new contracts with their original team or become free agents and sign with new teams. Having many free agents creates a secondhand market in baseball players. The original team can make an offer that will either retain a player or lose him to the free-agent market.

Asymmetric information is prominent in the free-agent market. One potential purchaser, the player's original team, has better information about the player's abilities than other teams have. If we were looking at used cars, we could test for the existence of asymmetric information by comparing their repair records. In baseball we can compare player disability records. If players are working hard and following rigorous conditioning programs, we would expect a low probability of injury and a high probability that they will be able to perform if injured. In other words, more motivated players will spend less time on the bench owing to disabilities. If a lemons market exists, we would expect free agents to have higher disability rates than players who are renewed. Players may also have preexisting physical conditions that their original teams know about that make them less desirable candidates for contract renewal. Because more such players would become free agents, free agents would experience higher disability rates for health reasons.

Table 17.1, which lists the postcontract performance of all players who have signed multiy ear contracts, makes two points. First, both free agents and renewed players have increased disability rates after signing contracts. The disabled days per season increase from an average of 4.73 to an average of 12.55. Second, the postcontract disability rates of renewed and not-renewed players are significantly different. On average, renewed players are disabled 9.68 days, free agents 1723 days.

table 17.1 Player Disability

Days Spent on Disabled List per Season

Precontract

Postcontract

Percent Change

All players Renewed players Free agents

1255 9.68 17.23

165.4 103.4 268.9

This example is based on Kenneth Lehn's study of the free-agent market. See "Information Asymmetries in Baseball's Free Agent Market," Economic Inquiry (1984): 37^14.

These two findings suggest a lemons market in free agents that exists because baseball teams know their own players better than the other teams with which they compete.

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