The market for lemons

"The market for lemons: quality uncertainty and the market mechanism" is a 1970 paper published by George Akerlof, an economist.

Akerlof's lemons state that...

• When consumers do not get the right information or lack the relevant information on the benefits or harm that they are likely to receive from the consumption of the good (see information failure from the previous post), producers will lower product quality.
• Consumers will expect producers to improve on the quality of product by lowering their willingness to pay
• Prices will then decline
• Producers have no choice but to lower quality even further to make profits at even lower prices
• Ultimately, quality will decline till what that's left are the lemons of lowest quality.
• Producers can't sell high quality goods at high prices even though buyers would be willing and able to pay for the high quality goods.
• So, market fails! Yay!

Now, we shall take a look at second hand cars. As mentioned by the econs lecturer if you're not dozing away like yaowen during lecture, second hand cars can be classified into 2 categories, mainly the lemons and the plums. Lemons represent bad cars, and plums the opposite. Imagine that in a market....

1. There are 10 lemons and 10 plums.
2. Consumer are willing to sell $1 for lemons, $2 for plums.
3. Producers are willing to pay $2 for lemons, $4 for plums.
4. If there's no information failure, ideal equilibrium price for lemons would be between $1 ~ $2 while for plums, it would be between $2 ~ $4.
5. However, here comes the problem. There is no assurance of quality and hence consumers will be kept in the dark about the quality.
6. If the consumer were to assume that there is a 50% chance of getting either a plum or lemon, then the he/she would be willing to pay (0.5)(2)+(0.5)(4) = $3. This price is less than the price expected from selling plums, thus only lemons would be offered for sale.
7. However, if a consumer is certain that he is getting a plum, he would be willing to pay anywhere between $2~$4.
   
8. Even though the price is within the producers' price expectation of plums, no such transaction will take place.
9. The consumer can only find out whether he/she has purchased a lemon or a plum after purchasing the object.

Also, this means that an owner of a car which is still in good condition will be unable to fetch a high enough price to make selling that car worthwhile. Thus, owners of good cars will not sell them to the second hand car market. This can be otherwise summarized as "the bad drive out the good" in the market.

In conclusion, moral hazard is the lack of incentive to take care. It works under the assumption that if you have an insurance, then the percentage chance of being cheated is lower. Less insurance leads to more risk, and more insurance leads to less care.

-yuncheng