"Lemon" products, or products with bad performance and low durability, are often bought due to a lack of information that can lead people into bad purchases and bad investments, instead of avoiding the product entirely. Timely, relevant information is crucial for functional, efficient markets. However, in certain industries and for some credence goods, consumers may not be able to thoroughly evaluate the goods or services they are thinking about purchasing. This leads to the possibility of consumers purchasing lemons.
Origins of the Lemons Problem Theory
The lemons problem theory was described by George Akerlof in a 1970 paper titled "The Market for Lemons: Quality Uncertainty and the Market Mechanism."
Akerlof explained how asymmetric information provides incentives for sellers of low-quality goods to present their products as high-quality goods, thus reducing overall product quality and consumer satisfaction. The "market mechanism" Akerlof refers to–where the bad drives out the good when only the average quality of goods in a market are considered–results in a no-trade equilibrium.
Akerlof postulated that, in some cases, certain markets may fail entirely because of this market mechanism in which there is a high degree of uncertainty about product quality. George Akerlof shared the 2001 Nobel Memorial Prize in Economic Sciences with Michael Spence and Joseph Stiglitz for their research into asymmetric information.
Solutions to Asymmetric Information
There are almost always going to be situations where consumers will not be able to make an educated purchasing decision, increasing the probability of the lemons problem. Asymmetric information and the lemon market problem are prevalent in many industries, most prominently in the automobile, banking, healthcare, pharmaceutical, and professional services industries.
Increasing the Amount of Information
Fortunately, there are solutions to the problem of asymmetric information. Among these solutions, increasing the access to information is paramount. Giving consumers greater access to information directly addresses the problem of asymmetric information. It is nearly impossible to provide every consumer with all the information they need to make an informed purchase decision in each instance, but if consumers can obtain enough information to make an educated decision, overall product quality can be increased, along with aggregate consumer satisfaction.
Consider once again the previous example of a used car market. A consumer without access to any external information would most likely have to rely on the word of the dealer. Access to information, such as a website, helps address the problem of asymmetrical information. Consumers may be able to check a dealer's track record on a website or they could find a list of local mechanics who can examine the used car before the purchase is made. If previous buyers are able to post comments on the website, new buyers may be forewarned about an unscrupulous dealer selling lemons. Consumers could even educate themselves regarding basic mechanical and electrical issues that could be problematic in a low-quality car.
Solutions to the Lemon Problem
Of course, there is more than one solution to the problem of asymmetric information, or "how to avoid buying a lemon."
Guarantees and Warranties: Guarantees and warranties benefit both the firm, by attracting customers with an assurance of higher quality goods and services, as well as consumers who, in the case of receiving a faulty product, can return the item or have it replaced. Almost all electronic device makers, for example, offer warranties.
Industry Standards: Firms may set requirements to produce goods and services that meet industry standards, thus attracting customers who might not be able to properly evaluate the industry's products and services. This method is practiced most often by high-quality producers of goods and services who wish to differentiate themselves from low-quality producers.
External Product Certification: Similar to creating industry standards, firms may attain external product certification so that consumers can rely on expert verification of the quality of their goods and services.
Consumer Protection Regulation: In many industries and governments act to address asymmetric information by implementing consumer protection laws designed to set a standard by which all firms must legally comply. For example, credit card issuers are subject to consumer protection laws set forth by the government.
Liability Laws: Liability laws are part of consumer protection regulations as established by the government. Firms may be subject to penalties and fines if minimum industry standards are not met.
Licensing: Licensing falls under consumer protection regulations as well. A firm, such as a public utility, might require a license by the government to sell certain goods and services.
Social Regulation: Social regulation is a significant measure taken by the government when other consumer protection laws fail to provide adequate regulatory functions. Oversight of a nation's banking industry is a type of social regulation designed to protect everyone.
When consumers aren't able to fully assess the things they are purchasing, there is always a chance they are going to get a lemon. Access to information, coupled with other market and regulatory solutions, can reduce the probability of the lemons problem and increase product quality and overall consumer satisfaction.