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December 14, 2018 

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MARKET FOR LEMONS:

A market adversely selects only lower quality products for exchange. The market for lemons is an illustration of adverse selection that results from asymmetric information. In this market, because buyers have limited information they offer an average price based on the average quality of the goods. Sellers, however, with better information select to sell lower quality products but not higher quality ones. Two methods of address this problem are signalling and screening. Two related information problems are moral hazard and the principal-agent problem.
The market for lemons is textbook example of adverse selection, illustrating how a market can select to exchange only lower quality products. Because buyers have less accurate information about the quality of goods, they are likely to offer a lower price, which discourages sellers from offering higher quality goods.

This problem arises due to asymmetric information, which is when different people have different information. Asymmetric information occurs because even though information is beneficial it is costly to acquire. Some people are bound to find it more beneficial or less costly to acquire information than do others. They know more, others know less. When buyers know less than sellers, then adverse selection is likely to result.

Adverse selection is commonly seen in the market for used cars and provides the textbook example for the market for lemons.

Buying a Used Car

To illustrate the market for lemons consider the exchange of used cars. Because this market has cars of varying quality, quality that is known to sellers but not to buyers, it is fertile ground for adverse selection.

Let's set the stage for this illustration with the market for used OmniMotors XL GT 9000 sports coupes.

  • First, the market has two different qualities of cars -- gems and lemons. Gems have been well maintained, are unlikely to need any repair, and are high quality cars. Lemons are not been well maintained, are likely to require some repair work, and are low quality cars.

  • Second, buyers have an equal chance of buying gems or lemons and have no way of knowing which is which until after the purchase. If buyers have complete information about the quality of the cars, then they would be willing to pay $8,000 for a gem and only $2,000 for a lemon.

  • Third, sellers know if they have gems or lemons and they know how much their cars are worth. The seller of a gem knows it is worth $8,000 and the seller of a lemon knows that it is worth $2,000.
Because buyers have an equal chance of purchasing a gem or a lemon the price they offer is the expected value of the purchase. The expected value of the car is equal to the probability of buying a gem times the price of the gem plus the probability of buying a lemon times the price of the lemon.

In this example, the expected value and the price offered is $5,000. In other words, if 100 cars are sold, half worth $2,000 and half worth $8,000, then the average price is $5,000. Moreover, the chance of paying $3,000 too much for a lemon is offset by the chance of paying $3,000 less than the value of the gem. It's a gamble.

Unfortunately, sellers have better information and know whether their XL GT 9000s are lemons or gems. At a $5,000 offer price, those selling lemons are more than willing to sell, coming out $3,000 ahead. In contrast, those selling gems are not willing to sell. They would receive $3,000 less than the value their cars.

The end result is that the ONLY cars sold are lemons. The market deals exclusively in lemons. The market adversely selects against the higher quality products in favor of the lower quality ones.

Possible Solutions

The problems caused by adverse selection found in the market for lemons can be lessened through signalling and screening.
  • Signalling: This is the provision of small bits of information that is intended to indicate other more complete information. Sellers, for example, knowing that buyers have less information about their products might pass along signals about product quality. Guarantees and warranties are common signals. Brand names established over long periods of customer satisfaction and/or advertising are another method of signalling. Of course, the signals might not be accurate and those with less quality products might deceptively mimic the signals of the higher quality goods.

  • Screening: This is the attempt by those with limited information to identify indicators suggesting more complete information. Employers, for example, commonly use grade point averages, aptitude tests, or school quality as a means of screening out high quality from low quality prospective employees. Of course, screening can also be inaccurate. A good student, from a good school, with a high grade point average, might be a lousy worker.

Related Problems

Adverse selection found in the market for lemons is one of three problems arising from asymmetric information. The other two are moral hazard and the principal-agent problem.
  • Moral Hazard: Moral hazard exists when one person undertakes an action that is detrimental to another person after the two people have entered into an agreement. The problem is that the person harmed is unaware of the actions of the other. It is most commonly seen in the insurance industry. Once the driver has insurance, moral hazard occurs if the driver changes behavior -- drives faster, takes more risks, or fails to obey traffic laws.

  • Principal-Agent Problem: The principal-agent problem is a disconnection or conflict between the goals and objectives of the "principal" and those of the "agent" authorized to represent the principal. The problem arises because the principal does not have accurate information about the behavior of the agent. This problem is common in corporations, when the owners (principals) hire managers (agents) to run the company. The agents, however, might make decisions that benefit themselves (higher salaries, fringe benefits) that are unknown to and not in the best interests of the owners (profit).

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Recommended Citation:

MARKET FOR LEMONS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: December 14, 2018].


Check Out These Related Terms...

     | economics of information | information search | asymmetric information | adverse selection | moral hazard | principal-agent problem | rational ignorance | signalling | screening |


Or For A Little Background...

     | scarcity | efficiency | sixth rule of ignorance | production | consumption | opportunity cost | scarce resources | market |


And For Further Study...

     | public choice | innovation | good types | market failures | financial markets | institutions | rational abstention | risk | uncertainty | risk preferences | risk aversion | risk neutrality | risk loving | marginal utility of income |


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