The Market for Lemons
"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper, by the economist George Akerlof which examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind. A lemon is an American slang term for a car that is found to be defective only after it has been bought.
Suppose buyers can't distinguish between a high-quality car (a "peach") and a "lemon". Then they are only willing to pay a fixed price for a car that averages the value of a "peach" and "lemon" together (pavg). But sellers know whether they hold a peach or a lemon. Given the fixed price at which buyers will buy, sellers will sell only when they hold "lemons" (since plemon < pavg) and they will leave the market when they hold "peach" (since ppeach > pavg). Eventually, as enough sellers of "peach" leave the market, the average willingness-to-pay of buyers will decrease (since the average quality of cars on the market decreased), leading to even more sellers of high-quality cars to leave the market through a positive feedback loop.
Thus the uninformed buyer's price creates an adverse selection problem that drives the high-quality cars from the market. Adverse selection is the market mechanism that leads to a market collapse.
Akerlof's paper shows how prices can determine the quality of goods traded on the market. Low prices drive away sellers with high-quality goods leaving only lemons behind. Akerlof, Michael Spence, and Joseph Stiglitz jointly received the Nobel Memorial Prize in Economic Sciences in 2001, for their research related to asymmetric information.
Akerlof's paper uses the market for used cars as an example of the problem of quality uncertainty. A used car is one in which ownership is transferred from one person to another, after a period of use by its first owner and its inevitable wear and tear. There are good used cars ("peaches") and defective used cars ("lemons"), normally as a consequence of several not-always-traceable variables, such as the owner's driving style, quality and frequency of maintenance, and accident history. Because many important mechanical parts and other elements are hidden from view and not easily accessible for inspection, the buyer of a car does not know beforehand whether it is a peach or a lemon. So the buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of a car of known average quality. This means that the owner of a carefully maintained, never-abused, good used car will be unable to get a high enough price to make selling that car worthwhile.
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