The Market for Lemons

"The Market for 'Lemons': Quality Uncertainty and the Market Mechanism" is a widely cited seminal paper in the field of economics which explores the concept of asymmetric information in markets. The paper was written in 1970 by George Akerlof and published in the Quarterly Journal of Economics. The paper's findings have since been applied to many other types of markets. However, Akerlof's research focused solely on the market for used cars. Akerlof examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, which ultimately leaves goods that are found to be defective after purchase in the market, noted by the term 'lemon' in the title of the paper. In American slang, a lemon is a car that is found to be defective after it has been bought. Akerlof's theory of the "Market for Lemons" paper applies to markets with information asymmetry, focusing on the used car market. Information asymmetry within the market relates to the seller having more information about the quality of the car as opposed to the buyer, creating adverse selection. Adverse selection is a phenomenon where, buyers result in buying lower quality goods due to sellers not willing to sell high quality goods at the lower prices buyers are willing to pay. This can lead to a market collapse due to the lower equilibrium price and quantity of goods traded in the market than a market with perfect information. Suppose buyers cannot distinguish between a high-quality car (a "peach") and a "lemon". Then they are only willing to pay a fixed price for a car that averages the value of a "peach" and "lemon" together (pavg). But sellers know whether they hold a peach or a lemon. Given the fixed price at which buyers will buy, sellers will sell only when they hold "lemons" (since plemon < pavg) and they will leave the market when they hold "peaches" (since ppeach > pavg).