Market failure in light of non-expected utility

This paper merges the non-expected utility approach (Tversky and Kahneman, J Risk Uncertain 5:297-323, 1992 and Quiggin, J Econ Behav Organ 3:323-343, 1982) into Akerlof's (Quart J Econ 84:488-500, 1970) model of Market for Lemons. We derive the results for different probability weighting functions and analyze the phenomenon of market failure in light of non-expected utility maximization. Our main finding suggests that when the proportion of traded lemons is high (low), the problem of market failure is mitigated (enhanced). In addition, for the case of Cumulative Prospect Theory, we show that (a) the higher the loss aversion is, the more pronounced is the market failure; (b) gain-domain elevation is negatively related to the extent of market failure; and (c) the value function is (i) negatively monotonic in the gain-domain diminishing sensitivity parameter when the market is characterized by a high proportion of "peaches," and (ii) positively monotonic in the loss-domain diminishing sensitivity parameter when the market is characterized by a high proportion of "lemons."