On the market for "Lemons": quality provision in markets with asymmetric information

George Akerlof's 1970 "Lemons" paper is a cornerstone of economic theory, establishing the "Lemons Result": in markets where consumers cannot pre-purchase assess product quality (credence and experience goods), the introduction of a low-quality product will displace higher-quality alternatives. This paper challenges this conclusion by examining instances where low- and high-quality products coexist. The food industry offers a prime example: despite consumer perception of genetically modified (GM) products as inferior, both GM and conventional products maintain market presence. Other examples include used cars, news sources, event tickets, and various professional services where quality is hidden. This study aims to define the conditions allowing for the coexistence of differing quality products within a market characterized by asymmetric information.

The paper references Akerlof's seminal work (1970) and reviews existing literature on mechanisms and outcomes in markets with hidden information (Auster and Gottardi, 2019). It cites research on consumer perceptions of GM products (Lusk et al., 2014; Kalaitzandonakes et al., 2016) and analyses of GM product market integration (Fulton and Giannakas, 2004; Giannakas and Yiannaka, 2008). The Mussa and Rosen model of vertical product differentiation (1978) provides the theoretical framework for analyzing consumer preferences and producer costs. The concept of probabilistic goods (Fay and Xie, 2008; Zhang et al., 2015) is also discussed in relation to the pooled product created by the mixing of high and low-quality goods.

The authors employ a simple model based on Mussa and Rosen's vertical product differentiation framework. They consider consumers with varying preferences for quality (α) and producers with differing production costs (A). Consumer utility functions are defined for high-quality (Uh), low-quality (Ul), and substitute (Us) products. Producer net return functions are similarly defined for high-quality (Πh), low-quality (Πl), and alternative (Πs) production. When low-quality products enter, consumer uncertainty leads to a 'pooled product' (Up) with utility based on the perceived probability (ψ) of low-quality. The model analyzes four scenarios based on the relative common (wh, wl) and idiosyncratic (γA, δA) costs of producing high- and low-quality products: 1. **Scenario I:** Lower total costs for all producers for low-quality production (wh + γA > wl + δA for all A). This scenario leads to the complete displacement of high-quality products (consistent with Akerlof's Lemons Result). 2. **Scenario II:** Lower acquisition costs (wl < wh) but higher idiosyncratic costs (δ > δ+) for low-quality production. In this case, high-quality products are produced by less efficient producers who find the increased idiosyncratic cost of low-quality production outweighs the advantage of reduced common costs. 3. **Scenario III:** Higher acquisition costs (wl > wh) but lower idiosyncratic costs (δ < γ) for low-quality production. This mirrors Scenario II, except that high-quality products are supplied by more cost-efficient producers who prefer to retain this production strategy. 4. **Scenario IV:** Higher total costs for all producers for low-quality production. The low-quality product fails to enter the market. The model derives equilibrium conditions (quantities and prices) under perfect competition for each scenario. The authors note that although they focus on perfect competition, qualitative results remain consistent under imperfect competition. Mathematical expressions for equilibrium under both market structures are provided in supplementary information.

The study demonstrates that Akerlof's "Lemons Result" is not universally applicable. The introduction of a low-quality product does not always eliminate higher-quality alternatives. Coexistence is possible and arises from differential production costs. The model reveals that the relative magnitudes of common and idiosyncratic production costs associated with low-quality goods determine the equilibrium market outcome. Specifically: * **Scenario I (Lemons Result):** If the total cost (common + idiosyncratic) of producing the low-quality product is lower than the total cost of producing the high-quality product for all producers, then only the low-quality product will exist in the market. * **Scenario II (Coexistence):** When the common cost of producing the low-quality product is lower but idiosyncratic costs are high enough (wl < wh and δ > δ+), then both high-quality and low-quality products will coexist, with higher-cost producers opting for high-quality production. * **Scenario III (Coexistence):** If the common cost of the low-quality product is higher but idiosyncratic costs are lower (wl > wh and δ < γ), then coexistence also occurs, but it is the more efficient producers who supply the high-quality product. * **Scenario IV (Low-quality product fails to enter the market):** When the total cost of producing low-quality products is higher than for high-quality products across all producers, the low-quality product will fail to enter the market. The study uses graphical representations (Figures 1-7) to illustrate producer net returns and market equilibrium conditions under each scenario. Equations (4)-(7) provide the mathematical formulations for key variables.

The findings significantly expand the understanding of market behavior in situations of asymmetric information. The model demonstrates that simple cost differences can lead to outcomes that deviate from Akerlof's prediction. The coexistence of high- and low-quality goods is not merely a market anomaly; it can be a stable equilibrium under specified conditions. This highlights the importance of considering the distinct cost structures associated with product quality when analyzing markets. The results have implications for policy interventions aimed at promoting quality or regulating the market. For example, policies designed to eliminate low-quality products might unintentionally harm market efficiency or reduce the availability of goods for some consumer segments.

This paper identifies conditions under which the introduction of a low-quality product in markets with hidden information does not drive out higher-quality products but instead coexists with them. This contrasts with the traditional "Lemons Result." The key to this coexistence is the differential impact of production technologies on common and idiosyncratic costs. Future research could explore the welfare implications of this coexistence, examine specific market contexts in more detail, and analyze the role of policies aimed at improving market transparency.

The model presented is simplified and utilizes certain assumptions, such as perfect or imperfect competition. The study focuses primarily on market equilibrium and does not conduct a detailed welfare analysis, leaving this open for further investigation. The impact of consumer preferences on the model's results could be further examined, including scenarios that deviate from uniform ranking of quality preference. The model also assumes that the low-quality and high-quality goods are undifferentiated in the marketplace which does not always hold true.