The Market for Lemons and the Regulator's Signalling Problem

Abstract: The Market for Lemons is a classic model of asymmetric information first studied by Nobel Prize economist George Akerlof. It shows that information asymmetry between the seller and buyer may result in market collapse or some sellers leaving the market. "Lemons" in the used car market are cars of poor quality. The information asymmetry present is that the buyer is uncertain of the cars' true quality. I first offer a simple baseline model that illustrates the market collapse, and then examine what happens when regulation, ie. a DMV is introduced to reveal (signal) the true car quality to the buyer. The effect on the market varies based on the assumptions about the regulator. The central focus is on the DMV's signal structure, which can have interesting effects on the market and the information asymmetry. I show that surprisingly, when the DMV actually decreases the quality of their signal in a well constructed way, it can substantially increase their profit. On the other hand, this negatively effects overall welfare.