Akerlof’s “Market for Lemons”: A Critical Comment

The effects of information asymmetries on the coordinating role of the market is probably one of the most discussed topics in the history of modern economic science. The neoclassical paradigm assumes that economic agents possess perfect information that allow them to make utility-maximizing decisions, which means that information asymmetries are left out of the neoclassical models.

Yet, most of the time, individuals and firms do not have access to all the relevant information, which could potentially lead to suboptimal or pareto-inefficient outcomes. In 1970, Nobel-awarded economist George A. Akerlof published an influential article where he analyzed market inefficiencies resulting from information asymmetries. Particularly, he looked at the used-car market in the US to illustrate his theory.

The Market for Lemons

Let me briefly summarize Akerlof’s paper. When purchasing a used car, the buyer faces an information problem, namely: she does not know whether the car will be good or a lemon (a term that refers to those used cars that have been poorly treated or repaired.) Unlike other goods, defective cars are difficult to identify due to the complex nature of the car-manufacturing process. In addition, the seller has an incentive to hide information about the car (number of repairs, manufacturing defects, etc.) in order to obtain the highest price possible.

This leads risk-averse buyers to underpay for used cars due to the uncertainty involved in the transaction. Similarly, sellers, unable to obtain a fair price, are not willing to sell higher-quality cars. As a result, the used-car market would be plagued with so-called lemons or lower-quality cars. In other words, information asymmetries would lead to a market failure. In some cases, the author argues, the market would completely disappear due to insuperable information asymmetries.

A Questionable Example

First of all, it must be noted that the used-car market is not the best example of difficult-to-overcome information asymmetries. As acknowledged by Akerlof himself: “it should be emphasized that this market is chosen for its concreteness and ease in understanding rather than for its importance or realism.”

In effect, there are many market mechanisms (that is, solutions that do not involve new government regulations) through which quality uncertainty in the used-car market can be minimized. It is well-known that car manufacturers use differentiation techniques to market their vehicles and make them more attractive to consumers. For instance, if one purchases a second-hand Mercedes or Volkswagen, it is less likely that the car be a lemon. Therefore, the lack of information is partly offset by the reputation of the car manufacturer.

Even if we admitted that private transactions of used cars would inevitably result in win-lose transactions in a high percentage of the cases, this would pose an opportunity for second-hand car dealers that would have an incentive to make sure the vehicles they sell are not defective or in poor state. This in turn would move buyers away from private sellers in favor of car dealers. As shown, there is a viable, market alternative that eliminates some of the information asymmetries that could emerge.

Source: http://blog.toyotaofclermont.com

Adverse Selection in the Health Insurance Industry

Both market mechanisms (brand naming and entrepreneurs taking advantage of profitable opportunities) are touched upon by Akerlof in his paper. However, the author goes beyond and extrapolates the used-car market example to other goods or services. Particularly, Akerlof applies the so-called Lemons Model to the health insurance industry, one of the classical examples of an industry that has been traditionally thought to give rise to inefficiencies due to adverse selection and information asymmetries.

Akerlof draws on a classic textbook on health insurance to explain adverse selection in the industry:

Generally speaking, policies are not available at ages materially greater than sixty-five… The term premiums are too high for any but the most pessimistic (which is to say the least healthy) insureds to find attractive. Thus, there is a severe problem of adverse selection at these ages.

In other words, to avoid adverse selection, health insurance companies are especially cautious when it comes to insuring older people or people that are more prone to get sick (to use the author’s terminology, lemons). According to Akerlof, this is an argument in favor of government intervention in health care.

This seems to be confirmed by the high percentage of uninsured people in the US. But is a market failure resulting from adverse selection the reason why many people do not have health insurance in the US? If we look at 2009 numbers (before mandatory insurance was established by law), this seems at the very least questionable. As pointed out by Megan McArdle, if uninsured people were excluded from the insurance market due to adverse selection, the percentage of uninsured people who are in poor health would be much larger than that of insured people in poor health. However, this is not the case: 10.3% of the uninsured are in poor health versus 8.4% of the insured.

Akerlof’s paper is of the utmost importance for pointing out that information asymmetries could potentially cause a suboptimal allocation of resources. Yet the main example he employs to make his case (the market for used cars) does not represent substantial market-coordination problems that can’t be overcome through other market mechanisms. In addition, adverse selection does not seem to apply to the health insurance industry, at least not in an important and substantial manner.

Finally, the fact that economic agents (and especially entrepreneurs) do not possess full information does not prevent them from making optimal decisions based on available information. The heuristic and dynamic process whereby agents buy, sell or invest within the market framework allows them to learn by trial and error, overcoming in the long run the initial lack of knowledge.

Luis Pablo is a Ph.D. Candidate in Economics at the University of Valladolid. He’s interested in macroeconomics, monetary theory and finance.