Lemon problem
Often the people or firms on one side of an economic transaction know more than those on the other side.This information asymmetry leads to adverse selection: among the informed parties, those who are most eager to make a deal are the least desirable to parties on the other side.Adverse selec- tion is a big idea in economic theory, because the problem arises in many types of markets.
The Lemons Problem
In 1970, George Akerlof of the University of California, Berkeley, published the classic paper on adverse selection; he won the Nobel Prize in Economics in 2002.Akerlof presented a folksy example about used cars to show how adverse selection causes markets to malfunction.
Consider the market for 2010 Honda Accords.These cars vary in qual- ity: some are good, and some are “lemons” that are constantly in the repair shop. If everyone knew the quality of each Accord, the used-car market would work well.The price of each car would reflect its quality. Good cars would sell for more than lemons, so every seller would get what his car is worth.
The market would also function all right if nobody knew the quality of each Accord. All cars would look alike, so there would be a single price for any Accord.This price would reflect the average quality of Accords. It would be below the price of a car that people knew to be good but above the price of a known lemon.
Akerlof, however, considers an intermediate case in which information is asymmetric.The seller of a car knows its quality because she has experi- ence driving it. But the buyer does not know the quality: to him, all Accords look alike.
Buyers’ ignorance means there will be a single price for all Accords, as in the case when nobody observes quality. One might guess that this price will reflect the average quality of all Accords. But now there is a problem. If owners of good cars see a price based on average quality, they will realize that this price is less than their top-notch cars are worth.They will hold onto the
The Lemons Problem
In 1970, George Akerlof of the University of California, Berkeley, published the classic paper on adverse selection; he won the Nobel Prize in Economics in 2002.Akerlof presented a folksy example about used cars to show how adverse selection causes markets to malfunction.
Consider the market for 2010 Honda Accords.These cars vary in qual- ity: some are good, and some are “lemons” that are constantly in the repair shop. If everyone knew the quality of each Accord, the used-car market would work well.The price of each car would reflect its quality. Good cars would sell for more than lemons, so every seller would get what his car is worth.
The market would also function all right if nobody knew the quality of each Accord. All cars would look alike, so there would be a single price for any Accord.This price would reflect the average quality of Accords. It would be below the price of a car that people knew to be good but above the price of a known lemon.
Akerlof, however, considers an intermediate case in which information is asymmetric.The seller of a car knows its quality because she has experi- ence driving it. But the buyer does not know the quality: to him, all Accords look alike.
Buyers’ ignorance means there will be a single price for all Accords, as in the case when nobody observes quality. One might guess that this price will reflect the average quality of all Accords. But now there is a problem. If owners of good cars see a price based on average quality, they will realize that this price is less than their top-notch cars are worth.They will hold onto the