Akerlof’s Lemon problem is a very interesting economic theory which is used to widely justify consumer and producer behaviour. In his research paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism”, George Akerlof uses lemons to signify defective goods. The central problem was mainly connected to the concept of asymmetric information. The lemon problem exists in the market place for both consumers and producers. Additionally, it is also prevalent in the financial and investment sectors. In the corporate realm, a lender has asymmetrical information about the creditworthiness of the borrower.
The problem of asymmetrical information mainly arises because buyers and sellers do not possess equal information about a product. The buyers do not have adequate information required to make an informed decision regarding a transaction. However, the seller is usually fully aware of the quality of the product he is selling. Akerlof’s original example was centred on cars- he assumed that some cars were of ‘high quality’ whereas others were ‘lemons’.
The big question that arises in this situation is – why would someone sell a perfectly good car unless it’s a “lemon”? Exceptions like people relocating to a different country and such are rare and not accounted for. So, the buyer assumes the reason behind selling the car and refuses to pay a higher price. Another integral question is brought up- Why sell a good car at a bad price? Following these ideals leads to only lemons remaining unsold in the market. Using economic concepts we can infer that asymmetric information led to this adverse choice- which in turn caused the market failure for good cars. It is obvious that sellers know more than buyers about the quality of the product they’re selling.
A lot of people note that Akerlof’s observation is a modified version of Gresham’s law which talks about how bad money drives out the good. Akerlof, on the other hand, represented the problem using a mathematical model that deeply analysed the central problem of the existence of defective goods in the market. His model laid the foundation for a diverse study of other real-world problems.
If buyers could successfully tell which cars are lemons and which are not, the market would be divided into two separate shares- a market for lemons and a market for high-quality cars. However, due to asymmetric information, buyers cannot tell them apart-, to some extent, a buyer knows that the car that he purchases might turn out to be a lemon. This lower price for all second-hand cars often discourages the sellers to sell high-quality cars- since the buyers can never be 100% sure that their car will not end up as a lemon, they will obviously not be willing to jeopardize and pay a full price, even for the high-quality cars.
By stating this problem, Akerlof tried to explore different solutions to this lemon problem. He pointed out that many ‘free-market institutions’ can play a crucial role in solving or reducing this problem. The most effective solution to the problem came in the form of warranties because these assure that the car purchased by the buyer will not end up as a lemon. However, warranties can be offered by sellers who are sure that none of their products will end up being lemons. Akerlof went beyond the car market and explained that this same problem arises in credit markets as well as Health Insurance markets.
Other solutions to this problem include having close to complete information about the product. A consumer without any external information will most likely have to rely on the dealer’s word of assurance. Accessing websites helps address this problem- consumers may be able to check the seller’s track records. Shopping sites such as Amazon and Flipkart, where customers are able to post their experiences while purchasing a product help to reduce the widespread problem of having asymmetric information.
Apart from warranties, other effective solutions include firms setting industry standards. They may fix requirements to produce goods and services that meet a certain standard. This method is mainly adopted by high-quality producers who wish to distinguish themselves from other low-quality producers. Many industries implement consumer protection laws designed to set a standard that all firms must legally comply with. For example, credit card issuers have to follow consumer protection laws to retain their business licenses. Social regulation is also a salient measure undertaken by the government when other consumer protection laws fail.
Akerlof’s lemon problem laid the foundation for the theory of markets with asymmetric information- this revolutionised the world of economics. Akerlof, along with fellow economists Michael Spence and Joseph Stiglitz, was also awarded the Nobel Prize in 2001 for their research on the lemon problem. Using this theory, several of his contemporary and future economists have explained crucial theories related to market failure due to inadequate information. Akerlof’s ability to use a single simple example to define and solve such an integral economic problem is what makes him an appreciable figure.
Investopedia. (2020, March 23) What is the Lemons Problem? Retrieved from: https://www.investopedia.com/terms/l/lemons-problem.asp
The Hindu. (2018, August 16) What is lemons problem ib Economics? Retrieved from: https://www.thehindu.com/opinion/op-ed/what-is-lemons-problem-in-economics/article24698187.ece