[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

A
B
AVERAGE QUALITY OF USED CARS
Quality
curve
PRICE OF USED CARS
Demand
curve
E
Supply
curve
PRICE OF USED CARS
Figure 15.1
A MARKET WITH LEMONS
QUANTITY OF USED CARS
Panel A shows the average quality of a used car increasing as the price increases.
Panel B shows a typical upward-sloping supply curve, but a backward-bending demand
curve. Demand bends back because buyers know that quality is lower at lower prices,
and they thus choose to buy less as the price falls. Panel B shows the market equilibrium
is at point E.
George Akerlof of the University of California at Berkeley has provided a simple
explanation, based on imperfect information. Some cars are worse than others. They
have hidden defects that become apparent to the owners only after they have driven
the cars for a while. Such defective cars are called lemons. One thing after another
goes wrong with them. While warranties may reduce the financial cost of having a
lemon, they do not eliminate the bother—the time it takes to bring the car into the
shop, the anxiety of knowing there is a good chance of a breakdown. The owners, of
course, know they have a lemon and would like to pass it along to someone else.
Those with the worst lemons are going to be the most willing to sell their car. At a
high used-car price, they will be joined by owners of better-quality cars, who perhaps
just want to replace their cars with the latest model. As the price drops, more
of the good used cars will be withdrawn from the market as the owners decide to
keep them. And the average quality of the used cars for sale will drop. We say there
is an adverse selection effect. The mix of those who elect to sell changes adversely
as price falls.
Figure 15.1 shows the consequences of imperfect information for market equilibrium
in the used-car market. Panel A depicts, for each price (measured along the
horizontal axis), the average quality of used cars being sold in the market. As price
increases, average quality increases. Panel B shows the supply curve of used cars.
As price increases, the number of cars being sold in the market increases, for all
the usual reasons. The demand curve is also shown. This curve has a peculiar shape—
upward as well as downward sloping—because as price decreases, the average quality
decreases. But demand depends not just on price but on quality—on the “value”
being offered on the market. If, as price falls, quality deteriorates rapidly, then the
334 ∂ CHAPTER 15 IMPERFECT INFORMATION IN THE PRODUCT MARKET