The market for lemons

Blessing Nyatanga

Introduction

In 1970 George Akerlof introduced the concept of market for lemons which attempted to establish asymmetric information in markets. This concept encompasses human behaviour when buyers have little to no information when faced with purchasing products. Akerlof, however, sorely focused on the market of used cars and this article will pre-empt the market for lemons concept.

Akelof examined how the quality of second hand cars traded in the market would degrade between buyers and sellers in the presence of information asymmetry. The term information asymmetry refers to a situation when one party has more information than the other.

The term is widely used between the buyer and the seller of a product. In essence the seller possesses greater material knowledge about their products.

This entails performance, defects and quality. It is true to say because the seller knows much about their product, there are chances that they may choose to hide these defects or they may be entirely honest but because the buyer does not have knowledge of this, it creates a grave challenge in price determination.

The market for lemons was derived from the American slang ‘lemon’ which referred to second hand cars found to be defective after it had been bought.

It is imperative at this juncture to demystify the market for lemons using second hand cars.

When a buyer intends to sell their second hand car, it is implied knowledge that they possess full information of the car that is regarding its state, its mileage as well as its defects while the buyer does not know all this.

However the buyer has a perceived price for the car judging on market value and when the seller tags their price judging on their information, the buyer will make a judgment based on the price.

Let’s assume at this point that it’s a very good second hand car with much durability and no defects, the seller will tag a higher price because of the car worthiness and because the buyer does not have knowledge on that car, the price may be too high for them yet in essence it’s a fair price based on its performance.

In another scenario, the seller of the second used car could still put a relatively lower price on the car because they are desperate for quick cash and yet the car has no defects and is in good condition but because the buyer has a perceived value for the car, they will feel the price is too low for a good car and will feel it is only being sold that low because it has defects.

All these scenarios present a grave challenge of information asymmetry.

This in essence is what George Akerlof was trying to drive in this concept.

The market lemons creates adverse selection and this is a phenomenon where, buyers result in buying lower quality goods due to sellers not willing to sell high quality goods at the lower prices buyers are willing to pay.

This can lead to a market collapse due to the lower equilibrium price and quantity of goods traded in the market than a market with perfect information.

The concept of market for lemons degenerates into adverse selection and could ultimately lead to the buyer having regret in the event of purchase.

The buyer may feel they paid too much for the car if they discover defects at a later stage or they will feel they bargained if the car surpasses their expectations and performs better than perceived.

The major setback with this phenomenon is that it drives out high quality cars from the market and leaves on the lemons referring to cars with defects.

High quality cars are driven from the market because of perceived prices by buyers, and it will oblige sellers not to sell because they know these cars would sell for a higher price. Let us assume that the buyers had full information on products and knew exactly what they would get for the given prices , it largely suggest that the market would have prices fairly set and perceptions would be just about accurate.

All the buyers in the market assume that any second hand product is of average quality and will set a value in their minds accordingly.

Some individuals service their cars religiously and are naturally good handlers of cars hence renders the average mentality void. To circumvent this challenge, some may suggest a test drive or taking their mechanic to the car sale albeit not sufficient because some defects are veiled prim facie.It will only take more driving to reveal the defects.

This indicates that information is a very imperative as far as trading is concerned .Once one party possesses greater material knowledge than the other, perceptions in prices will always differ.

Conclusion

Information asymmetry presents a grave challenge in the market for second hand cars and other tradable products. Buyers will always perceive a certain value for a second hand product as they do not possess material knowledge .

Given that the seller has full information they could manipulate that or fairly price their product on the market.

The concept of market for lemons could be mitigated by ensuring sufficient checks and inspection. In the case of purchasing a car, it would be prudent to take a mechanic to the car sale to check for quality and defects.

Blessing Nyatanga holds a Bachelor’s Degree in Banking and Investment Management from NUST.0784909184/[email protected]