Akerlof's market for lemons and information asymmetry

Economics

Doing business in emerging markets can be risky. If the risk of something like corruption was known, it could be priced into a transaction. With the costs of dishonesty are not known, however, that represents asymmetric information that may discourage investment altogether. Using the analogy of a used car market, Akerhof explains the importance of discouraging dishonesty to the maintenance of a healthy, functioning market.

Akerlof writes about the "market for lemons," discussing the issue of the economic costs of dishonesty. His model is the used car market, where there are vehicles of varying grades, each unique, and dishonesty about the quality can have an effect on the price of the vehicle. The article seeks to uncover some truths about how these types of markets operate. He points out that information asymmetry is like dishonesty, in that one party does not know what the intent of the other party is. Eventually, this can lead to market failure. This situation is applicable to developing nations as well, where dishonesty and corruption are a form of information asymmetry. Akerhof shows how dangerous this can be for an economy -- up to and including market failure.

Response to Question #1

Akerlof notes that there is asymmetric information in the used car market in that the seller always knows more about the quality of the car than does the buyer. A buyer may not be able distinguish between vehicles of differing quality, if there is no differential in the price. He notes that this can lead to market failure. His argument is that bad vehicles can drive out the market for better vehicles. Buyers can become suspicious, so that they are unwilling to purchase. This takes down the market not only for the lemons but for anything that might look like a lemon. He argues this point based on utility, in that a buyer who is unable to differentiate between quality levels is unable to ascertain utility. This reduces the likelihood that the buyer would even purchase any car. The market could, in theory, fail entirely, although the author notes that this is unlikely to occur in the real world.

Conclusion

Akerhof shows with the used car example how high the costs of dishonesty can be. For those in public policy or in business, this is an important finding. When dishonesty is likened to information asymmetry, the economic implications become clear -- there are high costs associated with dishonesty, and this holds a lot of countries back. He argues that if honesty is implemented, the market will grow stronger.

As consumers trust in the used car lot, or industry for that matter, they are more likely to buy. In response to this reality, the industry has focused on building a link between price and quality. The price signals the quality to the consumer. Without that link, the consumer would not be able to differentiate between a high quality vehicle and a low quality one. The result is market failure. When the link is created, consumers can trust that an expensive vehicle is a high cost one, and a cheap vehicle is a low cost one. This creates enough trust to have a functioning market for used cars.

When applied to developing nations, it becomes clear that there are high costs associated with corruption, primarily in lost business. Any firm that cannot protect its interests in some way will not enter the market, for fear of being ripped off. Remove this fear and you remove a significant barrier to investment. A more robust environment would emerge.