Definition of the lemon problem
What’s wrong with lemons?
The lemons problem refers to issues that arise regarding the value of an investment or product due to asymmetric information held by the buyer and seller.
The theory of the lemon problem was advanced in a 1970 research paper titled, The market for “lemons”: uncertainty of quality and market mechanism, written by George A. Akerlof, economist and professor at the University of California, Berkeley.
Understanding the problem with lemons
In his article, Akerlof examined the used car market and illustrated how the information asymmetry between seller and buyer could cause the market to collapse, wiping out any profitable trading opportunity and failing to leaving only “lemons”, or mediocre products with low durability that the buyer bought without sufficient information.
The problem of information asymmetry arises because buyers and sellers do not have the same amount of information needed to make an informed decision about a transaction. The seller or owner of a product or service usually knows its true value, or at least knows whether its quality is above or below average. However, potential buyers usually do not have this knowledge because they are not aware of all the information the seller has.
Akerlof’s original example of buying a used car noted that the potential buyer of a used car cannot easily determine the vehicle’s true value. Therefore, they may be willing to pay only an average price, which they perceive as something between a bargain price and a premium price. Taking such a position may at first appear to offer the buyer some financial protection against the risk of buying a lemon. Akerlof pointed out, however, that this position actually favors the seller, as receiving an average price for a lemon would always be more than what the seller could get if the buyer knew the car was a lemon.
Ironically, the problem with lemons creates a disadvantage for the seller of a high-end vehicle, because the asymmetric information of the potential buyer – and the resulting fear of getting stuck with a lemon – means that it doesn’t he is unwilling to offer a higher price for a higher quality vehicle. value.
Solutions to the problem of lemons
The problem of lemons exists in the consumer and commercial product market, as well as in the investment arena, related to the disparity in the perceived value of an investment between buyers and sellers. The problem of lemons is also prevalent in the financial sector, including the insurance and credit markets. For example, in corporate finance, a lender has asymmetric and less than ideal information about a borrower’s actual creditworthiness.
Akerlof offered strong guarantees as a way to overcome the lemons problem, as they can protect a buyer from any negative consequences of buying a lemon. Another solution that Akerlof was unaware of when he wrote the article in 1970 is the explosion of readily available and widespread information that was disseminated via the Internet and also helped to reduce the problem. For example, information services like Carfax and Angie’s List help buyers feel more confident about making a purchase, and they also benefit sellers by allowing them to charge higher prices for truly premium products.