A market for lemons

⊕Akerlof says this paper was rejected by The American Economic Review and The Review of Economic Studies as trivial, then rejected by The Journal of Political Economy with the line “if this paper was correct, economics would be different,” before QJE accepted it. He later shared the 2001 Nobel Prize in Economic Sciences for analyses of markets with asymmetric information, the line of work that includes “Lemons.” See Akerlof’s Nobel essay.For most cars traded will be the “lemons,” and good cars may not be traded at all.

Bad cars taint buyers’ image of the secondary market. So price falls. So people with good second-hand cars stop selling there. So average quality falls. So price falls again.

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.

Information asymmetry about quality drives out high-quality products, lowers prices, and shrinks markets.

Akerlof runs the same logic into insurance. For older folk, premiums rose, so the only people still willing to buy were the ones expecting higher costs, so the costs that the insurer expects to incur rose, so premiums rose again, so the pool got sicker again. Adverse selection becomes a spiral.

Trust as a substitute for transparency in asymmetric markets

Akerlof suggests a bunch of counter-moves. To me, they are all based on relationships.

Brand, trust in a reseller, and guarantees bind the buyer to a seller or intermediary. A guarantee seems to be the clearest case: even if quality is uncertain at purchase, the buyer can rely on their relationship with the seller, which has become legally enforceable.

The other relationships are more like parasocial trust bonds. A seller is granted awards, or certifications that they have met standards. A buyer has a parasocial relationship with the institutions that grant those awards and certifications (⊕And, of course, we can trust Akerlof on this because he won a Nobel Prize.*Akerlof explicitly cites the Nobel Prize and the Nobel Committee as an example). So a buyer feels more confident in their purchase.

So, when a buyer cannot know the quality of a good being sold, the market can still be healthy if they can rely on trust to bridge that information asymmetry.