Market Equilibrium with Private Knowledge

Abstract

The effect of asymmetric information between buyers and sellers on product quality was first explored by Akerlof (1970) in his pathbreaking paper on the market for ‘lemons’. He showed that if all purchasers have imperfect information on quality, then a market for the product may not exist, or if it does function it may not be efficient. These results have led to a number of papers concerning insurance and labor markets under different assumptions regarding how agents discriminate between ‘products’ of varying quality [see Pauly (1974), Rothschild and Stiglitz (1976), Wilson (1977), Miyasaki (1977), and Spence (1978)].

The research in this paper is partially supported by the Bundesministerium für Forschung und Technologie, F.R.G., contract no. 321/7591/RGD 8001 and NSF grant 5–22669. While support for this work is gratefully acknowledged, the views expressed are the authors’ own and are not necessarily shared by the sponsor. We are grateful to Zenan Fortuna and Serge Medow for computational assistance and to David Cummins, Michael Riordan and Peyton Young and the participants in the Conference on Regulation of the International Institute of Management, Berlin, July 1981, especially Jorg Finsinger and Paul Kleindorfer, for helpful comments and suggestions. An earlier version of this paper is included in the conference proceedings.