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'

RELATED TERMS
  1. Lemon

    A very disappointing investment. A lemon is an investment in ...
  2. Lemon Laws

    Regulations that attempt to protect consumers in the event that ...
  3. George A. Akerlof

    A winner of the 2001 Nobel Prize in Economics, along with Michael ...
  4. Asymmetric Information

    A situation in which one party in a transaction has more or superior ...
  5. Purchase-Money Mortgage

    A mortgage issued to the borrower by the seller of the home as ...
  6. Plum

    A choice investment, or one that has outperformed other comparable ...
Related Articles
  1. Managing Wealth

    How To Avoid Buying A "Lemon" Product

    A lack of information can lead people into bad purchases and bad investments. Find out how you can avoid these lemons.
  2. Managing Wealth

    Did You Buy A Lemon?

    Find out how to fix a sour deal on your car purchase.
  3. Insurance

    What Does Asymmetric Information Mean?

    Asymmetric information describes a situation where one party in a transaction knows more than the other.
  4. Investing

    The Ins And Outs Of Seller-Financed Real Estate Deals

    There's more than one way to buy or sell a house. Seller financing presents yet another unique option.
  5. Investing

    Ins And Outs Of Seller-Financed Real Estate Deals

    Seller financing works like this: Instead of a buyer receiving a loan from a bank, the person selling the house lends the buyer the money for the purchase.
  6. Personal Finance

    Used Car Shopping: How To Avoid A Lemon

    Being prepared before buying will save you thousands in the long run.
  7. Personal Finance

    Car Shopping: New Or Used?

    Don't get taken for a ride. Learn the pros and cons before the salesperson makes a pitch.
  8. Investing

    The Pros and Cons of Owner Financing

    Details on the upside and risks of this type of deal for both the owner and the buyer.
  9. Investing

    What is a Financial Market?

    “Financial market” is a broad term used to describe any forum where buyers and sellers meet to trade assets.
  10. Investing

    Rent-To-Own Homes: How The Process Works

    A rent-to-own agreement can benefit homebuyers with bad credit or insufficient funds for a down payment. Here’s how one works.
RELATED FAQS
  1. What is the theory of asymmetric information in economics?

    Read a brief overview of asymmetric information theory in economics, the development of its main arguments and why some challenge ... Read Answer >>
  2. How do financial market exhibit asymmetric information?

    Understand how financial markets exhibit asymmetric information. Learn how asymmetric information by any party can result ... Read Answer >>
  3. How significant is asymmetric information risk?

    Learn about the presence of asymmetric information risk in the financial markets and how various parties present or are exposed ... Read Answer >>
  4. Do any markets not exhibit asymmetric information?

    Find out why every market possesses information asymmetry, and why this isn't necessarily a huge or insurmountable problem ... Read Answer >>
  5. How can the problem of asymmetric information be overcome?

    Find out how market actors deal with the problem of asymmetric information, particularly when it leads to possible adverse ... Read Answer >>
  6. How does adverse selection contribute to market failure?

    Examine an brief introduction to the adverse selection theory of market failure, and find out why economists disagree about ... Read Answer >>
Hot Definitions
  1. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  2. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  3. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  4. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  5. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  6. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
Trading Center