Many of us have bought used or pre-own cars (I have bought three in Dallas Texas) and had the experience of wondering if the price you were paying was fair, or if the car was a lemon under the Texas lemon law.
Back in 1970, economist George Akerlof examined this issue. He wrote a paper entitled “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” While he took the used car market as an example, his writing was applicable to many more buyer/seller situations.
Two aspects of the used car transaction were important to Akerlof. Not all used cars (or new cars) are of the same quality – some are in good condition and are solid vehicles, while others have many defects and are undesirable for potential buyers. This wide range of conditions reflects the quality heterogeneity of the pool of vehicles.
The second aspect was the asymmetry of information between the seller and the buyer. The seller may know a great deal about the vehicle being sold while the buyer knows very little. Additionally, some buyers will be able to more accurately assess the true condition of the vehicle that they are purchasing.
Akerlof theorized that a purchaser of a used car would not know if the car was good or was a lemon, therefore, the buyer would assume that the car’s quality was somewhere in the middle, an ‘average quality’ and therefore would only be willing to pay an ‘average price.
Following from this, a seller of a very good used car would only be able to get an average price – not a fair price for the car. A seller of a poor quality used car will still try to get the buyer to believe that the quality of the car is higher than it really is and will try to get a price higher than what the car is worth. From this, if a seller, who had lots of knowledge about a car, knew that it was a good car, he would want to keep it; and if the seller was eager to sell, why should a buyer want to buy it. This would result in only poor quality used cars for sale and no one willing to take the risk to buy them.
In the years since his work, the used car market has not disappeared. Economists have continued to debate why this is and the merits of Akerlof’s conclusions. One thing that Akerlof does not take into consideration is the desire for new and trendy vehicles. Many consumers sell well maintained and well running cars in order to buy some new design or more stylish model. Many people do not view a car purely from an economic perspective.
In 2001 Akerlof was one of the winners of the Nobel prize in Economics for his work on situations where buyers and sellers operate with different information.