Why can a market collapse when only the seller knows the quality?

Because buyers cannot tell a good car from a bad one, they offer a price for the average car, and that price is an insult to the owners of the good ones. In American slang a lemon is a car that turns out to be defective after you buy it, and a good one is a peach. Many important mechanical parts are hidden from view, so a buyer cannot know beforehand which one is on offer. The buyer's best guess is average quality, so that is what the buyer will pay. The seller, though, knows exactly what the car is.

Now follow the incentives. The owner of a carefully maintained, never-abused car will not be able to get a high enough price to make selling it worthwhile, so that car stays in the driveway. The owner of a lemon happily sells. With the good cars gone, the average quality on the market drops, and buyers revise their expectations downward. That pushes the owners of moderately good cars out too, and so on. The process repeats until a no-trade equilibrium is reached: the market has eaten itself. Low prices drive away sellers of high-quality goods, leaving only lemons behind.

This is called adverse selection: a situation in which asymmetric information lets one party use undisclosed information to benefit more from a trade. George Akerlof described it in a 1970 paper, "The Market for Lemons". The journals he sent it to were not impressed. Two rejected it as trivial, a third as incorrect, since if it were right, they argued, no goods could be traded. It was accepted on the fourth attempt, became one of the most-cited papers in modern economic theory, and earned Akerlof a share of the 2001 Nobel Prize.

The same trap catches more than cars. Akerlof pointed to scarce formal credit in developing countries and to the difficulties that older people have in buying health insurance.