Lemons Problem

What is the 'Lemons Problem'

The lemons problem refers to issues that arise due to asymmetric information possessed by the buyer and the seller of an investment or product, regarding its value. The lemons problem was put forward in a 1970 research paper, "The Market for Lemons," written by George Akerlof, an economist and professor at the University of California, Berkeley. The tag phrase identifying the problem came from the original example of used cars that Akerlof used to illustrate the concept of asymmetric information, as defective used cars are commonly referred to as "lemons."!--break--The lemons problem is recognized as existing in the marketplace for both consumer and business products, and also in the arena of investing, related to the disparity in the perceived value of an investment between buyers and sellers. The lemons problem is also prevalent in financial sector areas, including insurance and credit markets. For example, in the realm of corporate finance, a lender has asymmetrical and less-than-ideal information regarding the actual creditworthiness of a borrower.

Causes and Consequences of the Lemons Problem

The problem of asymmetrical information arises because buyers and sellers don't have equal amounts of information required to make an informed decision regarding a transaction. The seller or holder of a product or service usually knows its true value, or at least knows whether it is above or below average in quality. A potential buyer, however, typically does not have this knowledge, since he is not privy to all the information the seller has.

Akerlof's original example of the purchase of a used car noted that the potential buyer of a used car cannot easily ascertain the true value of the vehicle. Therefore, he may be willing to pay no more than an average price, which is perceived as somewhere between a bargain price and a premium price.

Adopting such a stance may at first appear to offer the buyer some degree of financial protection from the risk of buying a lemon. Akerlof pointed out, however, that this stance of the buyer actually favors the seller, since receiving an average price for a lemon would still be more than the seller could get if the buyer had the knowledge that the car was a lemon. Ironically, the lemons problem creates a disadvantage for the seller of a premium vehicle, since the potential buyer's asymmetric information, and the resulting fear of getting stuck with a lemon, means that he is not willing to offer a premium price even though the vehicle is of superior value.

Warranties and Information

Akerlof proposed strong warranties as one means of overcoming the lemons problem, as they can protect a buyer from any negative consequences of buying a lemon. The explosion of readily available, widespread information disseminated through the internet has also helped to reduce the problem. Information services such as Carfax and Angie's List help buyers feel more confident in making a purchase, and they also benefit sellers because they enable them to command premium prices for genuinely premium products.

BREAKING DOWN 'Lemons Problem'

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