7/17/2019 Lemons Problem

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A “lemon,”or a car that has been poorly maintained—by, for instance, not having its oil changed

regularly—could have damage to its engine that even a trained auto mechanic mighthave difficulty detecting. The prices that potential buyers are willing to pay for usedcars will reflect the buyers’ lack of complete information on the true condition of thecars. Consider a simple example: Suppose that you are in the market for a used 2008Honda Element. Suppose also that you and other buyers would be willing to pay $15,000 for a good, well-maintained car but only $7,000 for a lemon. Unfortunately,

 you cannot tell the lemons from the good cars, but you have read an online report thatindicates that about 75% of used 2008 Elements are well maintained, while the other25% are lemons. In Chapter 4, we introduced the concept of expected return, which iscalculated by adding up the probability of each event occurring multiplied by the valueof each event. In this case, we can calculate the expected value to you of a 2008 HondaElement you choose randomly from among those available for sale:

Or,

It seems reasonable for you to be willing to pay a price for a Honda Element equalto the expected value of $13,000. Unfortunately, you are likely to run into a majorproblem: From your perspective, given that you don’t know whether any particular caroffered for sale is a good car or a lemon, an offer of $13,000 seems reasonable. But thesellers do know whether they are selling good cars or lemons. To a seller of a good car,an offer of $13,000 is $2,000 below the true value of the car, and the seller will be reluc-tant to sell. But to a seller of a lemon, an offer of $13,000 is $6,000 above the value of 

the car, and the seller will be happy to sell.As sellers of lemons take advantage of know-ing more about the cars they are selling than buyers do, the used car market is subjectto adverse selection: Most used cars offered for sale will be lemons. In other words,because of asymmetric information, the used car market has adversely selected the carsthat will be offered for sale. Notice as well that the problem of adverse selection reducesthe total quantity of used cars bought and sold in the market because few good cars areoffered for sale. From Akerlof’s analysis of adverse selection in the used car market, wecan conclude that information problems reduce economic efficiency in a market.

To reduce the costs of adverse selection, car dealers act as intermediaries betweenbuyers and sellers. To maintain their reputations with buyers, dealers are less willing totake advantage of private information about the quality of the used cars that they areselling than are individual sellers, who will probably sell at most a handful of used carsduring their lifetimes. As a result, dealers sell both lemons and good cars at their true

values. In addition, government regulations require that car dealers disclose informa-tion about the cars to consumers.

Expected value   = (0.75   * $15,000)   + (0.25   * $7,000)   = $13,000.

+ (Probability car is a lemon)   * (Value if a lemon).

Expected value   = (Probability car is good)   * (Value if good)

256 CHAPTER 9 • Transactions Costs, Asymmetric Information, and the Structure of the Financial System