The Lemon — The Asymmetry, Plate i

The first and most famous of the failures begins with a used car. The man selling it knows whether it is sound or a lemon; the man buying it does not, and cannot, until he has owned it a while. From that small and ordinary gap — one side knowing the quality of a thing, the other knowing only that some are good and some bad — follows a result that overturned the easy faith that a market always finds its price.

Suppose, with George Akerlof, that used cars are of two kinds, good ones and lemons, and that sellers know which they hold but buyers cannot tell them apart. A buyer, unable to distinguish them, will pay neither the full price of a good car — he might be getting a lemon — nor the low price of a lemon — it might be good — but something in between, a price reflecting the average quality of the cars on offer. That single reasonable response sets in motion the machinery of ruin.¹

1. George Akerlof, "The Market for 'Lemons'" (1970): when sellers know quality but buyers know only the distribution, buyers rationally pay a price reflecting average quality. The paper, repeatedly rejected before publication, founded the economics of asymmetric information and shared the 2001 Nobel with Spence and Stiglitz.

For consider what that average price does to the seller of a genuinely good car. His car is worth more than the average — but the average is all the market will pay, because the buyer cannot see that his is the exception. Selling at the average means selling at a loss, so he withdraws his car and keeps it. But when the good cars withdraw, the average quality of those remaining falls — the pool is now more heavily lemons — and so the price the buyer will pay falls with it. At that lower price, the next tier of decent cars is overpriced relative to what it fetches, and those sellers withdraw in turn. The average falls again; the price falls again; and the market spirals downward, the good cars driven out at each round by the bad, until in the limit only lemons remain, or no one trades at all.²

2. The unravelling (adverse selection): at a price set by average quality, above-average goods are underpriced and withdraw; their exit lowers average quality and price, prompting the next tier to withdraw, and so on. The good is driven out by the bad — a Gresham's law for quality — until the market collapses to the worst goods or vanishes.

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The used car is only the homeliest instance of a phenomenon that recurs wherever the informed side selects itself into a market. In insurance, it is the applicant who knows his own health: offered a policy priced for the average person, the healthy find it a poor bargain and decline, the sick find it a good one and rush in, so the pool sickens, the premium must rise, the next-healthiest drop away, and the spiral runs as before — the very adverse selection the volume on the premium met at the edge of its pool. In lending, it is the borrower who knows his own intentions: raise the interest rate to cover defaults, and the prudent borrowers, who would have repaid, drop out, while the desperate and the reckless, who never meant to repay or never could, remain — so that a higher rate can attract a worse pool and lower the lender's return.³

3. Adverse selection generalizes: in insurance, average-priced cover attracts the unhealthy and repels the healthy (compare The Premium, plate The Pool); in credit, a higher interest rate can select riskier borrowers and lower expected return (Stiglitz and Weiss, 1981, on credit rationing). The informed side's self-selection turns the price against the market.

It is worth being exact about what has gone wrong, for the failure is of a particular and instructive kind. Nothing here is irrational; every party acts sensibly on what he knows. Nor is the trouble merely that some trades are mispriced. The trouble is that mutually beneficial trades do not happen at all: the owner of a good car and a buyer who would gladly pay its worth are both willing, both better off if they trade — and yet no price lets them, because any price the buyer will offer is, to him, a gamble against lemons, and any price the seller will take seems to signal that the car is bad. Good cars go unsold that both parties wished sold; sound risks go uninsured; creditworthy borrowers go unfunded. The market does not merely distribute badly, as the first family's prices did; it fails to exist where it should, destroying value no one wished destroyed. This is the signature of a market failure, and the asymmetry is among its purest cases.⁴

4. The failure is the destruction of mutually beneficial trades, not mere mispricing: good cars, sound risks, and creditworthy borrowers go untraded though both parties would gain, because no price can at once attract the buyer and credibly signal quality. The market fails to exist where it should — the mark of a market failure, distinct from the distributive concerns of Group I.

That any such market survives at all — that good used cars are in fact sold, that the healthy do buy insurance, that sound borrowers are funded — tells us that something must be working against the unravelling. That something is the apparatus the rest of the volume anatomizes: the devices by which the informed side credibly reveals what it knows, and the uninformed side induces it to. The seller offers a warranty no lemon-monger could afford to honor; the buyer demands an inspection; the dealer stakes a reputation; the insurer screens with a medical exam and a deductible; the lender requires collateral and a record. Each is a costly contrivance whose purpose is to put information where the price cannot — and each, we will find, is a charge that the asymmetry levies on every honest party for the dishonesty of the few.⁵

5. The survival of such markets implies countervailing devices — warranties, inspections, reputation, screening, collateral — that convey or extract the hidden information. These are the subject of the plates that follow (The Diploma, The Screen, The Warranty); each is a costly response to asymmetry, anticipating the flagship's account of how markets survive.

The lemon, then, is the disease in its simplest form: hidden quality, and the slow strangulation of a market by its own adverse selection, the good driven out by the bad until little but lemons is left. It is the first of the failures because it is the most elementary — a single gap in knowledge, and an unravelling that needs nothing more to run. The plates that follow take up the cures before returning, in the flagship, to the price itself. First the signal: the costly action by which the holder of a good car, or a good mind, or a sound risk, can prove it is good — when proving costs the liar more than the honest man, and so cannot simply be faked.