Lemons Problem

AAA

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.

INVESTOPEDIA EXPLAINS '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.

RELATED TERMS
  1. Clunker

    A popular reference to the old vehicle traded in under the U.S. ...
  2. Cash For Clunkers

    A program that allows car owners to trade in their old, less ...
  3. Adverse Selection

    1. The tendency of those in dangerous jobs or high risk lifestyles ...
  4. Asymmetric Information

    A situation in which one party in a transaction has more or superior ...
  5. Lemon

    A very disappointing investment. A lemon is an investment in ...
  6. Premium to Surplus Ratio

    Net premiums written divided by policyholders’ surplus. The premium ...
Related Articles
  1. Budgeting

    How To Avoid Buying A "Lemon" Product

  2. What is the impact of research on stock prices?
    Investing Basics

    What Is The Impact Of Research On Stock ...

  3. Investing Basics

    3 Essential Rules For New Investors

  4. Markets

    7 Signs A Stock Is Set To Slide

Hot Definitions
  1. Capitulation

    When investors give up any previous gains in stock price by selling equities in an effort to get out of the market and into ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Conduit Issuer

    An organization, usually a government agency, that issues municipal securities to raise capital for revenue-generating projects ...
  4. Financing Entity

    The party in a financing arrangement that provides money, property, or another asset to an intermediate entity or financed ...
  5. Hyperinflation

    Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is ...
  6. Gross Rate Of Return

    The total rate of return on an investment before the deduction of any fees or expenses. The gross rate of return is quoted ...
Trading Center