Market for lemons

B. Venkatesh

DR George Akerlof and two other notable economists have been awarded the Nobel Prize for their contribution to the research on information asymmetry. Dr Akerlof, in particular, is well known for introducing the `Market for Lemons' in this research area. What is the `Market for Lemons'?

Consider this. Suppose you want to buy a second-hand Maruti car. You find a couple of such cars in the second-hand automobile market. What are your first thoughts? You wonder why the owner is selling the car. Is it because the car has technical problem? Does it have a police record for accidents?

You, of course, ask the seller these questions who promptly replies he is selling the car because he wants to buy a bigger one. That does not satisfy you. So, you quote a price of Rs 1.25 lakh against his price of Rs 1.75 lakh.

You do that because of information asymmetry; that is, you do not have as much information about the condition of the car, as does the seller. Imagine what will happen if all buyers try to beat down the price of the car because of information asymmetry?

Look at it from a seller's perspective. He may have five cars to sell, two of which are in bad condition. Suppose the good cars are priced at Rs 2 lakh and the bad cars at Rs 1.75 lakh. Since you do not know whether the Rs 2 lakh is really good, you will try to bargain for a lower price. This actually motivates the seller to sell more bad cars! Why?

As you will any way bargain for a lower price, the seller would rather sell the bad cars than the good ones, because there is no way he can convince you of the actual condition of the cars. This will eventually drive out good cars from the market, a condition referred to as the `Market for Lemons' by Dr Akerlof.

The `Market for Lemons' also exists in areas such as insurance and bank-loans, where buyers have more information than the sellers.