Lemons Problem

DEFINITION of 'Lemons Problem'

The issue of information asymmetry between the buyer and seller of an investment or product. Lemons problem was popularized by a 1970 research paper by economist George Akerlof. The term is derived from Akerlof's demonstration of the concept of asymmetric information through the example of defective used cars, which are known as lemons in marketplace. In the investment field, the lemons problem is apparent in areas such as insurance and corporate finance.

BREAKING DOWN 'Lemons Problem'

Information asymmetry arises when the parties to a transaction do not have the same degree of information necessary to make an informed decision. For example, in the market for used cars, the buyer generally cannot ascertain the value of a vehicle accurately and may therefore only be willing to pay an average price for it, somewhere between a bargain price and a premium price.



However, this tilts the scales in favor of a lemon seller, since even an average price for this lemon would be higher than the price it would command if the buyer knew beforehand that it was indeed a lemon. This phenomenon also puts the seller of a good used car at a disadvantage, since the best price such a seller can expect is an average price, and not the premium price the car should command.

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