The Market for Lemons - Case Study Example

Running head: The Market for Lemons The Market for Lemons [The of the appears here] [The of appears here] Akerlof's 1970 paper "The market for lemons" is one of the well-known papers in academic economics. It is in general seen as having initiated to economics the concept of asymmetric information, and in doing so; flashing off what is now an entire branch of economics: the economics of information. It is a theoretical paper that more or less all economists, though untheoretical they might be, would now make out as important. It is as well a paper that just about every economic theorist would be keen on to have written. For the reason that, there are no argument on the subject of its value. Everyone can observe that this is a most important contribution to economics. Undoubtedly, Akerlof is asserting that his paper has something to say regarding an amazingly wide range of fact in the real world. In the case of the labor market, he appears to be promising to elucidate a number of features of the real world. However in the case of business in underdeveloped countries, he is merely intended for giving structure to a statement that is often made regarding the real world. At this point, the insinuation appears to be that Akerlof's model will one way or another reformulate an empirical proposition which is usually believed to be true. Akerlof then says that, although his theory has these very general applications, he will focus on the market for used cars: "The automobile market is used as a finger exercise to illustrate and develop these thoughts. It should be emphasized that this market is chosen for its concreteness and ease in understanding rather than for its importance or realism" (Akerlof, George, 1970) On first reading, it is tempting to interpret "the automobile market" as the market in which real people buy and sell real cars, and to think that Akerlof is going to present some kind of case-study. One can see why he might focus on one particular market which is easy to understand, even if that market is not very important on the scale of the economy as a whole. But then what does Akerlof mean when he says that this market is not realistic The object of a case-study may be unrepresentative, but it cannot be unrealistic. To make sense of this passage, we have to recognize that it marks a transition between the real world and the world of models. Akerlof is using the real automobile market as an example. But what he is going to present is not an empirical case study; it is a model of the automobile market. Although it is the real market which may be unimportant, it is the model which may be unrealistic. Akerlof moves straight on to the central section of his paper, section II, entitled "The Model with Automobiles as an Example." The transition from reality to model is made again at the very beginning of this section: The example of used cars captures the essence of the problem. From time to time one hears either mention of or surprise at the large price difference between new cars and those which have just left the showroom. The usual lunch table justification for this phenomenon is the pure joy of owning a "new" car. We offer a different explanation. Suppose (for the sake of clarity rather than realism) that there are just four kinds of cars. There are new cars and used cars. There are good cars and bad cars. (Akerlof, George, 1970) The first four sentences are about an observed property of the real world: there is a large price difference between new cars and almost-new ones. Akerlof suggests that, at least from the viewpoint of the lunch table, this observation is difficult to explain. If we assume that Akerlof takes lunch with other economists, the implication is that economics cannot easily explain it; the "pure joy" hypothesis sounds like an ad hoc stratagem to rescue conventional price theory. So far, then, the mode of argument might be Popperian: there is a received theory which makes certain predictions about market prices; observations of the used-car market are contrary to those predictions; therefore, a new theory is needed. www.thehindubusinessline.com But from the word "Suppose" in the passage above, we move out of the real world, and into the world of the model. Akerlof sets up an imaginary world which makes no pretence to be realistic. In this world, there are two groups of traders, "type one" and "type two." All traders of a given type are alike. There are n cars, which differ only in "quality." Quality is measured in money units, and is uniformly distributed over some range. Each group of traders maximizes an aggregate utility function. For group one, utility is the sum of the qualities of the cars it owns and the monetary value of its consumption of other goods. For group two, the utility function is the same, except that quality is multiplied by 3 / 2. Thus, for any given quality of car, the monetary value of a car to type one traders is less than its monetary value to type two traders. All cars are initially owned by type one traders. The quality of cars has a uniform distribution. The quality of each car is known only to its owner, but the average quality of all traded cars is known to everyone. (Guala, Francesco, 1999) Akerlof admits that these assumptions are not realistic: they are not even close approximations to properties of the real used-car market. He justifies them as simplifications which allow him to focus on those features of the real market that he wishes to analyze. For example, he defends his assumptions about utility (which implicitly impose risk neutrality) against what he takes to be the more realistic alternative assumption of risk aversion by saying that he does not want to get "needlessly mired in algebraic complication": "The use of linear utility allows a focus on the effects of asymmetry of information; with a concave utility function we would have to deal with the usual risk-variance effects of uncertainty and the special effects we have to deal with here" (Akerlof, George, 1970) Akerlof investigates what happens in his model world. The main conclusion is simple and startling. He shows that if cars are to be traded at all, there must be a single market price p. Finally, Akerlof shows what would happen in the same market if information were symmetric that is, if neither buyers nor sellers knew the quality of individual cars, but both knew the probability distribution of quality. In this case, there is a market-clearing equilibrium price, and trade takes place, just as the standard theory of markets would lead us to expect. Akerlof ends section II at this point, so let us take stock. What we have been shown is that in a highly unrealistic model of the used-car market, no trade takes place even though each car is worth less to its owner than it would be to a potential buyer. We have also been given some reason to think that, in generating this result, the crucial property of the model world is that sellers know more than buyers. Notice that, taken literally, Akerlof's result is too strong to fit with the phenomenon he originally promised to explain the price difference between new and used cars. Presumably, then, Akerlof sees his model as describing in extreme form the workings of some tendency which exists in the real used-car market, by virtue of the asymmetry of information which (he claims) is a property of that market. This tendency is a used-car version of Gresham's Law: bad cars drive out good. In the real used-car market, according to Akerlof, this tendency has the effect of reducing the average quality of cars traded, but not eliminating trade altogether; the low quality of traded cars then explains their low price. (Hausman, Daniel M, 1992) Remarkably, Akerlof says nothing more about the real market in used cars. Akerlof presents no evidence to support this claim that there is a large price difference between new and almost new cars. This is perhaps understandable, since he clearly assumes that this price difference is generally known. More surprisingly, he presents no evidence that the owners of nearly-new cars know significantly more about their quality than do potential buyers. And although later in the paper he talks about market institutions which can overcome the problem of asymmetric information, he does not offer any argument, theoretical or empirical, to counter the hypothesis that such institutions exist in the used-car market. But if they do, Akerlof's explanation of price differences is undermined. However, Akerlof has quite a lot to say about other real markets in section III of the paper, "Examples and Applications." In four subsections, entitled "Insurance," "The Employment of Minorities," "The Costs of Dishonesty," and "Credit Markets in Underdeveloped Countries," Akerlof presents what are effectively brief case-studies. These discussions are in the style that economists call "casual empiricism." They are suggestive, just as the used-car case is, but they cannot be regarded as any kind of test of a hypothesis. In fact, there is no hypothesis. Akerlof never defines the "Lemons Principle"; all we can safely infer is that this term refers to the model of the used-car market. Ultimately, then, the claims of section III amount to this: in these four cases, we see markets that are in some way like the model. The final part of the paper is section IV, "Countervailing Institutions." This is a brief discussion, again in the mode of casual empiricism, of some real-world institutions which counteract the problem of asymmetric information. The examples looked at are guarantees, brand names, hotel and restaurant chains, and certification in the labor market. The latter example seems to be what Akerlof was referring to in his introduction, when he claimed that his approach might "explain important institutions of the labor market." Here, the claim seems to be that there are markets which would be like the model of the used-car market, were it not for some special institutional feature; therefore, the model explains those features. (John H. Huston, Roger W. Spencer. 2002) From a Popperian perspective, sections III and IV have all the hallmarks of "pseudo-science." Akerlof has not proposed any hypothesis in a form that could be tested against observation. All he has presented is an empirically ill-defined "Lemons Principle." In section III, he has assembled a fairly random assortment of evidence which appears to confirm that principle. In section IV, he argues that the real world often is not like the model, but this is to be seen not as refutation but as additional confirmation. Reference: Akerlof, George (1970). "The Market for Lemons: Quality Uncertainty and the market Mechanism," Quarterly Journal of Economics Guala, Francesco (1999). Economics and the laboratory, PhD thesis, London School of Economics and Political Science Hausman, Daniel M (1992). The Inexact and Separate Science of Economics. Cambridge: Cambridge University Press John H. Huston, Roger W. Spencer (2002). Quality, Uncertainty and the Internet: The Market for Cyber Lemons; American Economist, Vol. 46 Read More