Akerlof's Lemons

George Akerlof asked a simple question: why are used cars so cheap? Not just because they’re used — the price drops far more than depreciation explains. His answer: buyers can’t tell good cars from lemons, but sellers can. Knowing this, buyers assume the worst and offer low prices. At those prices, owners of good cars won’t sell. So the market fills with lemons, confirming buyer suspicions. Quality flees; prices collapse.

This is the lemons problem: when buyers can’t verify quality, average price reflects average quality, which drives above-average quality out, which lowers average quality, which drives more quality out. The spiral can destroy the market entirely.

The mechanism is adverse selection applied to quality. Sellers of good cars would accept fair prices, but fair prices for unknown quality reflect the mix — and the mix keeps getting worse. Information asymmetry doesn’t just disadvantage buyers; it can eliminate transactions that would benefit everyone. The good-car seller and the discriminating buyer never find each other.

Solutions involve bridging the information gap. Warranties shift risk back to sellers who know quality. Certifications provide third-party verification. Brand reputation puts seller skin in the game across repeated transactions. Each mechanism fights adverse selection by making quality observable or making misrepresentation costly.

The lemons model extends beyond cars. Any market with quality variation and information asymmetry risks unraveling. Job markets with unobservable skills. Insurance markets with hidden health. Credit markets with hidden creditworthiness. Dating markets with hidden compatibility. The pattern is universal.

The practical implication: quality alone isn’t enough. Quality must be communicable. If buyers can’t distinguish you from lemons, you’ll be priced as a lemon. costly signaling exists because cheap signals are worthless when information asymmetry makes the market distrust all claims.