The Market for “Lemons”:
Quality Uncertainty & the Market
Mechanism
Akerlof
Presented By:
•Ahmed Mujtaba
•Ahmed Raza
•Annan Saeed
•Dilawar Qazi
•Haad Khan
•Rizwan Khan
•Tanveer Khan
The Idea
• This paper relates quality and uncertainty.
• Information asymmetry
• The bad driving out the good" in the market
• seller have incentive to sell inferior goods when
the quality of goods is difficult to identify.
• When the buyer is less informed about the
quality than the seller, adverse selection may
result.
Market for Used Cars
• This paper has taken the automobile market to
illustrate the points
• There are good used cars (cherries) and
defective used cars (lemons)
• Normally as a consequence of several notalways-traceable variables such as the owner's
driving style, quality and frequency of
maintenance and accident history car quality
falls (lemons)
• Because the buyer cannot tell the difference,
bad cars and good cars have to be sold at the
same price.
• Good car owners are locked in while lemons
stay on the market.
EXAMPLES OF AUTOMOBILES
Bad cars are denoted by lemon
Sellers betray their customers
This is common practice through out the world.
Sellers predict that they are selling good quality
cars but in real they give lemon.
Customers gets betrayed because of the
asymmetrical informantion
• The demand for used cars depend on their
quality and price.
• Mostly dependant on price.
• Asymmetrical information
• It is one of the factor that the buyers get
betrayed sometimes and don’t get the model he
is looking far .
Important point :
• just like we are discussing dishonesty in the
business world, the world will collapse if it
doesn’t stop.
• The sellers gets advantage while the buyer
doesn’t get full utility.
• The other factor is symmetrical inofrmation
If Information is Symmetric
• Note there is a maximum utility gain if the
equilibrium is established at symmetric
information
• With asymmetric information, no trade takes
place
Examples and Applications
Insurance: It is a well known fact that people over
65 years of age have great difficulty in buying
medical insurance.
Now why the price does not rise to match the risk?
The answer is..
☻But at average the result..
■ Generally speaking policies are not available for
at age greater then 65 years.
 Now the conclusion is that insurance company
are worry about giving medical insurance to
older people.
 Here the principle of adverse selection is
present in fact it is present in all lines of
insurance.
 Adverse selection?
 Adverse selection appears whenever the
individual or group insured has freedom to buy
or not to buy or plan of insurance or to
discontinue as a policy holder.
• In USA adequate health is the precondition for
employment which means the medical insurance
is least available to those who need it most so it
means insurance companies do their own
adverse selection.
• On cost benefit basis: attracts too many lemons
The employment of minorities
• Employer may refuse to hire members of
minorities groups for certain types of jobs.
• Profit maximization not irrationality
• To serve a good statistic for applicant’s social
background, quality of schooling, and general
job capabilities are important.
• The capabilities of children and mature student:
• Through educational establishment (e.g an
untrained worker with valuable natural talent)
• Unreliability of slum schools:
• Rational decision
• Benefit from training minority groups:
by raising average quality
by raising individual quality
• But return may be distributed over the whole
group.
Real World
Cost of dishonesty
▫ The presence of people who sell inferior goods tends
to drive out the legitimate business. It is not only are
the consumers cheated but also moral and legal
concerns rise.
▫ Expertise to tell the true value of undistinguishable
goods is easily directed to arbitrage rather than real
production purpose because the former is more
profitable in a world full of lemons.
Counteracting institutions
• Numerous institutions arise to counteract the
effects of quality uncertainty.
• one natural result of our model is that the risk is
borne by the seller rather than by the buyer.
• Institution which counteracts the effects of
quality uncertainty is the BRAND names.
• Brand names not only indicates but also give the
consumer a means of retaliation if the quality
does not meet the expectations.
Cont……
 New products are associated with old brand
names. This ensure the prospective consumer
of the quality of the product.
 Chains- such as hotel chains or restaurant
chains are similar to the brand names.
 Licensing practices also reduce quality
uncertainty. For example the licensing of the
doctors, lawyers, and barbers.
 Most skilled labor carries some certification
indicating the attainment of certain levels of
proficiency.
Real World
Credit market in underdeveloped countries
▫ Entrepreneurs have to turn to “managing agencies”,
people and companies with reputation and communal
influence, for financing a newly started firm.
▫ Rural credit market is dominated by loans with
extortionate rates from local moneylenders rather
than those with official rates from formal banks since
only the former have good access to borrower’s
information. Anyone who try to arbitrage tends to
lose.
Conclusion
• Trust is important
• Business will suffer as indicated by our
genralized gresham’s law but
• The difficulty of distinguishing good quality
from bad is inherent in the business world