The Market For Lemons Illustrated By Second Hand Car Market : Information Economics

The lemons problem theory was first raised by George Akerlof in 1970 on his research paper titled as 'The Market for Lemons: Quality Uncertainty and the Market Mechanism.' In second-hand car markets, lemons vehicles usually refer to those cars having poor performance or bad quality because of a variety of defects and issues. Those lemon products will be mixed together with the high quality cars.

Compared with the sellers, due to the lack of adequate information, it is very hard for buyers to identify the actual quality of a car. To avoid buying those low-quality lemon vehicles, buyers have to lower the bid price to decrease the potential loss in case of picking up a lemon car. As a result, the lower price will cause more good quality cars to exit the market and gradually a virtuous cycle will form. The end result will be that the market is full of lemon vehicles and there will be no good quality cars in the market.

To illustrate this theory clearly, let's think about this example. Let's assume that, on the first day, there are both good and bad quality cars in the market. For every 100 second-hand cars, there are 50 good quality cars and 50 poor quality cars. The real value of the better quality car is $40000, and the real value of the poor quality one is $20000. However, due to the fact that the seller will know exactly whether their car is a good one or a bad one, but the buyer do not know for sure if that one is good or bad. For those smart sellers, the best strategy is to declare that their car is a good one because the buyer can't tell the difference. So, although 50% of the cars in the market are bad quality cars, when buyers are asking for the quality for a specific car, all they can get from sellers is "this car is a good quality car". However, for a buyer, although they cannot tell if a specific car is good or bad, they definitely know that 50% cars in the market will be bad quality cars. They will realize that there is 50% probability that they will get a good car and 50% probability for a bad one. Considering this mathematical probability, the highest bid price they can offer for any specific car is $30000 [30000=20000x1/2+40000x1/2].

If this kind of things happening again and again. Some sellers of good quality cars have to sell their car in a low price and some other sellers will exit the market because they don't think it worth it. At the same time, more bad quality cars will enter the markets because the sellers of those cars will get more profits. When there are less good quality cars existing in the market, the situation is getting worse. For example, let's assume that the ratio of good quality cars to bad quality cars is dropping from 1:1 to 1:3. Now the buyers will only pay $25000 [25000=40000x1/4 + 20000x3/4] for a car. This new lower price will cause more good quality sellers to exit the market, and the virtuous cycle will form until there are no good quality cars in the market.

The cause of the lemon problem is the asymmetric information achieved in sellers and buyers. The sellers know the status of the product while the buyers do not. In extreme circumstances, the good quality products will be pushed out of the market and the market will shrink over time. The solution for the lemon problem will be providing sufficient information to buyers to let them know the exact quality of the products. In addition, there should be some places for the buyers to provide feedback or reviews for each seller. Also, some emerging technologies such as big data can help buyers to get better knowledge about the product. Nowadays, lots of countries has corresponding "Lemon Laws" which can help regulating the market and buyers can ensure that, quality-wise, they can get what they paid for.

Attribution:
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