Market for Lemons

Akerlof, 1970
A buyer wants to buy a car but does not know whether
the particular car he is interested in has good or bad
quality. About half of the market consists of good
quality cars. The buyer offers a price p to the seller who
is informed about the quality of the car. The seller may
then either accept or reject this price. If he rejects,
there is no sale and the payoff will be 0 to both. If he
accepts, the payoff to the seller will be the price minus
the value of the car, and to the buyer it will be the
value of the car minus the price. A good quality car has
a value of 15,000; a lemon has a value of 5,000. Set up
the extensive form of the game. Determine all Nash
and subgame perfect Nash equilibria.
 Set up
The set of players is:

= , ,

,

The type set of S is:

S = , ,

,
()

Set up
The valuations of B and S are:

5,000, =
= =
15,000, =
Set up
The strategies of B and S are:

= 0, ,

: 0, S , ,

,
The extensive form

Node 4

Node 5
Last stage
Node 4: If the car is good, the seller accepts if

15,000 0 15,000 (1)

Node 5: If the car is a lemon, the seller accepts p if

5,000 0 5,000 (2)

We can also write the conditions above as

, ( 15,000 = ) ( 5,000 = )
, =
,
Previous stage
The quality of the car is unknown to the buyer, but
he knows half of all the cars are good. He also
knows what the expected valuation of the seller is,
given the probabilities assigned by nature:

( ) = 0.5 + 0.5 = 10,000

Previous stage
A rational offer (given uncertainty or given the probabilities
associated with Nature) of payment p would thus be p=10,000.
B then updates beliefs about S being type L if S accepts this offer
of p=10,000:

(|)()
=
+ ()

By (1) and (2),

1(0.5)
= =1
1(0.5) + 0(0.5)

i.e., B is 100% sure that S is type L if S accepts

Previous stage
Thus,

= 1 5,000 10,000 + 0 15,000 10,000 = 5,000 0,

where .

Thus, B does not buy the car if S accepts p = 10,000

Previous stage
We also determine the best responses of B given
the G and L types of S if:

= 15,000
(10,000, 15,000)
(5,000, 10,000)
[0, 5,000]
Previous stage
If = 15,000, both the G-type S and the L-type S
accept it.
Then,

= 0.5 5,000 + 0.5 15,000 = 5,000 0

Thus, B does not buy the car.

Previous stage
If (10,000, 15,000), the G-type S rejects it and
the L-type S accepts it.
Then
= 1(5,000 ) 0.

Thus, B does not buy the car.

Previous stage
If (5,000, 10,000), the G-type S rejects it and
the L-type S accepts it.
Then = 1(5,000 ) 0. Thus, B does not
buy the car.
Previous stage
If [0, 5,000], the G-type S rejects it
and the L-type S accepts it if = 5,000 and rejects
it if < 5,000.
If S accepts p, then = 1 5,000 0
Thus, B buys the car. (3)
Conclusion
By (1), (2), and (3), the Nash equilibria and subgame
perfect Nash equilibria (which are infinite in number)
are:
( [, , ],
( 5,000 = ), ( 15,000 = ), ]

Interpretation: Trade occurs only if the cars being

traded are lemons. When the buyer offers a payment
equal to the average or expected valuation, only
lemon-sellers, who sell below-average cars, accept this
offer. Hence, there is an adverse selection of below-
average sellers.
Alternative approach for the
previous stage
The quality of the car is unknown to the buyer, but he knows half
of all cars are good. The buyer will rationally offer a p such that:

= 0.5 5,000 + 0.5 15,000 0

10,000

Given (1) and (2), the buyer concludes that if the seller accepts
5,000 10,000,
then the car is a lemon.
 Thus, the buyer will always offer p such that
5,000 0 5,000 (3)

By (1), (2), and (3),

the Nash equilibria and subgame perfect Nash equilibria
(which are infinite in number) are:

( [, , ],
( 5,000 = ), ( 15,000 = ), ]
References
Peters, H. (2008). Game theory: a multi-leveled
approach. Springer-Verlag Berlin Heidelberg.
Rasmusen, E. (2005, November 10). 9 Adverse
selection. Retrieved from Eric Rasmusen's
Homepage:
http://www.rasmusen.org/GI/chapters/chap09_ad
sel.pdf
Tadelis, S. (2013). Game theory: an introduction.
New Jersey: Princeton University Press.