The Art of Strategy: A Game Theorist's Guide to Success in Business and Life

by Avinash K. Dixit

George Akerlof chose the used car market as the main example in his classic article showing that information asymmetries can lead to market failures.3 To illustrate the issue in the simplest way, suppose there are just two types of used cars: lemons (bad quality) and peaches (good quality). Suppose that the owner of each lemon is willing to sell it for $1,000, whereas each potential buyer is willing to pay $1,500 for a lemon. Suppose the owner of each peach is willing to sell it for $3,000, whereas each potential buyer is willing to pay $4,000 for a peach. If the quality of each car were immediately observable to all parties, then the market would work well. All cars would be traded, lemons selling for a price somewhere between $1,000 and $1,500, and each peach between $3,000 and $4,000. But suppose each seller knows the quality of a car, whereas all that buyers know is that half the cars are lemons and half are peaches. If cars are offered for sale in the same proportion, each buyer would be willing to pay at most An owner who knows his car to be a peach is not willing to sell at this price.* Therefore only lemons will be offered for sale. Buyers, knowing this, would offer at most $1,500. The market for peaches would collapse completely, even though buyers are willing to pay a price for provable peaches that sellers are happy to accept. The Panglossian interpretation of markets, namely that they are the best and most efficient institutions for conduct of economic activity...