THE MARKET FOR ‘’LEMONS’’: QUALITY UNCERTAINTY AND THE MARKET
MECHANISM
The Market for Lemons was written by G. A. Akerlof in 1970 and discusses the effects of
asymmetric information and quality uncertainty on the market mechanism. Asymmetric
information occurs when one party knows more than the other party to do the transaction.
Additively, quality uncertainty arises when buyers cannot distinguish good products from
bad ones. These problems lead to malfunctioning of the market mechanism. However, their
effects can be reduced by offering warranties and licensing in some markets. This essay will
discuss asymmetric information and quality uncertainty's effects on the used cars, health
insurance, labor markets, and ways to reduce them in the used cars and the labor market.
In the used cars market, buyers analyze market statistics to derive a thought about average
product quality and price. They know that there are good and bad cars in the market but
cannot distinguish them. On the other hand, sellers know the quality of their cars. In other
words, buyers lack crucial information about cars' condition, which is where asymmetric
information arises. Usually, good cars worth more than the average price, and bad cars
worth less than the average price. What Akerlof says that when the average price is equal to
the below acceptance limit of the good product’s seller can accept, both good and bad
products are trading in the market. However, when the average price drops below that limit,
only bad products are trading in the market. The reason behind that is good car owners
know that they cannot afford a car of the same quality if they sell their products.
Nonetheless, bad car owners continue to sell because they still get more than their cars’
worth. On the other hand, due to the asymmetric information, buyers cannot become aware
that the market mostly contains bad cars. Even though they want to buy a good car, they
end up buying a bad car. When this occurs repeatedly, buyers' assumptions about the
average quality and price will go down, and up to the extreme point, all trading in the
market will freeze.
In the health insurance market, insurance companies set an average price for their service by
analyzing the citizens' health profiles in the area they operate. However, the insurance
companies can only predict the buyers’ healthiness; only the buyers exactly know their
health conditions. Like the buyers in the used car market, insurance companies, aka sellers,
lack the necessary information to do transactions in the health insurance market. Akerlof
says that only the ones with serious health problems, high-risk buyers, will buy the insurance
when the average price rises. This happens because, even though the prices are high, high-
risk buyers’ benefit from the insurance still exceeds the cost of obtaining it. If this is the case,
the insurance companies spent too much money to cover that insurers' health care costs.
Therefore, they do not want to take any more risk, even though there are low-risk buyers in
the market. Up to the extreme point, there will be no insurance sales at any given price.
In the labor market, employers look at the quality of schooling and social background while
recruiting employees. The minimum qualifications they want is a credible quality schooling
and a good social background. However, even though they check two critical indicators,
employers still lack one crucial information, which is the candidate's general capabilities and
talents, which is the point where asymmetric information pops up. For example, a poor,
intelligent person cannot afford a private school's tuition, so the person goes to the
community college. However, this college’s credibility may far below then the private one.
Thus, when this person graduates and applies for a new job, even though the person has the
potential and skills, the person will be eliminated because of the quality of schooling due to
lack of information about the person’s qualifications. Another example can be a person who
lives in the slums. When this person applies for a job, the employer who sees the address
may think that hiring this employee will disturb the company's working environment or think
that he/she will engage in misbehavior like stealing company property. In this case, the lack
of information about why the person lives here causes him/her to lose the job. Up to the
extreme point, all candidates who cannot satisfy minimum requirements will not be hired.
Different methods can be used in different markets to reduce asymmetric information's
effect on the market mechanism. For example, offering warranties for second-hand cars, and
licensing in the labor market can reduce asymmetric information. In used car markets, sellers
will offer warranties to buyers to ensure the quality of their cars. This will reduce the
asymmetric information and help the used car market to improve. In the labor market,
candidates who cannot meet the minimum requirements can prove the credibility of their
abilities by licensing. For example, they may attend exams to certificate their foreign
language level. Additionally, they may attend workshops to certificate their ability in a
particular area. By licensing their qualifications, they reduce the asymmetric information
problem of the employers.
To conclude, Akerlof draws attention to the effects of asymmetric information and quality
uncertainty on the market mechanism and explains them in the used car, insurance, and
labor market. He also explained some factors, which are warranties and licensing, help
reduce the asymmetric information in some of these markets.
REFERENCES
Akerlof, G. A. (1970). The Market for ''Lemons'': Quality Uncertainty and the Market
Mechanism.
