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 the lemons problem. We'll look at this problem in detail and provide some tips for resolving it.

TUTORIAL: Economics Basics

The Lemons Problem
The lemons problem theory states that certain industries are susceptible to asymmetric information, which can lead to a decrease in product price because the buyer is unsure about any potential problems that the asset might have, and will thus demand a deep discount. Asymmetric information occurs when a seller has more or better information than a buyer.

The lemons problem theory makes reference to unsuccessful investments that, like lemons, leave a bitter taste. The most common use of the term "lemon" is when it is applied to low-quality cars offered for sale in a used car market. (Find out how to fix a sour deal on your car purchase. See Did You Buy A Lemon?)

Asymmetric Info in Action
To understand how asymmetric information can produce a market of mostly low-quality goods and services, consider a used car market with only one type of car. One group of sellers is offering automobiles in good shape for $13,000, and another group is selling low-quality automobiles, or lemons, for $7,000. The average price that a buyer would be willing to pay for a car from this market is $10,000 ([$13,000 + $7,000]/2).

At a $10,000 average price point, only the sellers of low-quality cars will be willing to sell. Because sellers of high-quality cars want $13,000, most will not be willing to sell for $10,000. So this market would deal primarily in lemons, thus reducing overall product quality.

In addition to certain industries that are susceptible to asymmetric information, specific products or services known as credence goods are also prone to lemon problems. The utility of credence goods is difficult for a consumer to assess. Therefore, the value of such an item may be unclear, both before and after a consumer has purchased it.

It is reasonable to assume that consumers are able to judge the value of goods such as food, office supplies and appliances. However, it is difficult for consumers to fully value credence goods and services such as automobiles, dietary supplements and healthcare because of asymmetric information, leading to the possibility of the lemons problem. In terms of an auto purchase, for example, the numerous problems facing the vehicle might not surface immediately after the purchase.

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. (Before you try to profit from their theories, you should learn about the creators themselves. To learn more, read Nobel Winners Are Economic Prizes.)

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.

Increase 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. These include:

1. 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. (Warranties can have their own pitfalls. For more insight, see Extended Warranties: Should You Take The Bait?)

2. 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.

3. 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.

4. 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. (For more, see Consumer Protection Laws You Need To Know.)

5. Liability Laws
Liability laws are a 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.

6. 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. (For the flipside of this argument, see The Pitfalls Of Financial Regulation.)

7. Social Regulation
Social regulation is a significant measure taken by 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.

Bottom Line
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. (Being prepared before buying will save you thousands in the long run. Check out Used Car Shopping: How To Avoid A Lemon.)