Asymmetric Information and the End of Market

A review of the article The Market for “Lemons”: Quality Uncertainty and the Market Mechanism.

The Market for “Lemons” is a seminal work of George Akerlof, who emphasized the importance of asymmetric information in economic analysis. He used this analytical framework to explain why it is hard to establish market in developing nations, why certain insurance companies don’t insure elderly people despite having sound credit history, and why businesses not hiring certain race is probabily not due to racism but rational calculations.

This article is an extention of economic empricial law, the Gresham’s Law, which says that if two types of money are circulating in the market, the low qualitied money will drive out the good one. This law stem from the European history when people use silver coins for money. If I remembered correctly, French silver coins were manufactured by high qualitied silver with enough weight to represent the unit value, while other European countires used poor qualitied silver. When French coin has the same exchange rate with other coins, then people had the incentive to trade the bad ones in their posession for the good ones. Soon there are only bad silver coins circulating in the market.

Akerlof expanded this notion by noticing a critical fact. People can observe the quality of the coin. A question naturally follows, what if quality cannot be observed? Akerlof argued that the market for goods with unobservable qualities will demolish. He used the car market as an example.

There are two types of car, new one and used ones. Each type is associated with two states, good and bad. We often observe an interesting phenomenon where the value of a new car drops immediately after driving out of the window. The rationale is the following: only the driver knows the qualitiy of the vehicle, which creates a situation where people who sell the car knows more about the product the the potential buyers. For people who owns a used good car, their potential value is greatly damaged because they cannot sell their cars at the price of a new car; they cannot obtain diminished value as well because buyers couldn’t distinguishi between good and bad used cars, so good qualitied used cars cannot be sold at a higher price. That is, used cars must be sold at the same price, and since bad qualitied sellers have incentive to exhaust the extra profit from asymmetric information, then the bad qualitied cars will quickly flood the market and no good cars can be traded.

The story is especially enlightening. When obtaining additional informaiton on the quality is hard, people tend not to buy the product or will find other product with similar functioning. However, I wasn’t able to find the boundary of this theory, perhaps that is because I did not understand this article deep enough to raise new questions. Feynman once said, “what I cannot create, I do not understand.” Similar issues happend here, I only understood (I think) the story, but in which situation can this observation be extended or we can perform further analysis is still unknown. Say, suppose this theorem is true, then why do people still buy things? Quality is a subjective value different among agents, why markets still exist when the information about the product can be obtained after it is being consumed? You don’t know the quality of a TV or computer after you bought it and used it, then we should expect the market full of bad computers. But it is not the reality, then there must exist other factors we neglected. Perhaps that is why people buy brand products, because it is an insurance of the quality. Perhaps quality control is a random variable and the expected value is very close to 1 (given the range of quality from 0 to 1) for most of the products in an economy with good political structure and legal regulations.