Economic Classroom Experiments/Lemon Game

An optimistic buyer, who values an object more than its owner but knows less about its quality, finds out through repeat play that he or she is in a market for lemons and would be better off not to buy at all.

Overview

Level

Any level

Prerequisite knowledge

None

Suitable modules

Any

Intended learning outcomes

1. Concept of a lemon market and criteria for one to exist.
2. Preventative measures: lemon laws.

Computerized Version

A computerized version of this experiment is available on the Exeter games site.

You can quickly log in as a subject to try out this individual progress experiment. You may also find the sample instructions helpful.

Abstract

Students play individually as a buyer who bids to purchase an object from the computer in the role of seller. The seller knows the value of the object and will not sell it if the buyer bids less than it is worth. The buyer does not know the value of the object, knowing only the interval over which the value is uniformly distributed. The buyer values the object more than the seller and is willing to pay up to 1.5 times its value. Should the buyer bid and if so how much?

Discussion of Likely Results

In the default setup, values are uniformly distributed over the interval £0 to £1. If the buyer makes a bid of b, the seller will only sell the object if the value to the seller is less than b. Thus, if it is sold it will on average have a value of b/2. The object is worth 1.5(b/2) = 3b/4 to the buyer, so the buyer's profit is -b/4 and the conclusion is that the buyer should not bid at all (bid 0).

The market for second hand cars is an example of a lemon market. There is asymmetry of information because the seller knows more about the quality of the car than the buyer. The seller of a bad car has a strong incentive to sell it at a much higher price than it is worth and the buyer is insufficiently protected by regulation or warranties in this case. Conversely, it is difficult for the seller of a good car to demonstrate its quality to the buyer. The result is that bad cars tend to out-number good ones in the market. This is an explanation as to why the price of a new car drops so rapidly once it leaves the showroom; see The Market for 'Lemons': Quality Uncertainty and the Market Mechanism by Akerlof (1970).