The market for Lemons – Informational Asymmetries leading to Market Failures
Informational Asymmetry refers to a situation in which among the parties involved in transactions, one party has more information than the other. This creates an imbalance of power in transactions. Considering a buyer seller example, seller has more information about the quality of his product than the seller.
The market for lemons is a very famous paper that explains how asymmetric information leads to the collapse of markets.
Consider a used cars market. A used car is one in which ownership is transferred from one person to another, after a period of use by its first owner and its inevitable wear and tear. There are good used cars termed as Cherries and bad used cars known as lemons. Informational asymmetry builds in from the fact that the buyer of the car cannot tell beforehand that whether the car is a cherry or lemon Because many important mechanical parts and other elements are hidden from view and not easily accessible for inspection As quality is undistinguishable to buyer he will just have to guess about the quality. The best guess that the buyer will make is that the car is of average quality and will be willing to pay average price. Numerically, lets assume a cherry owner asks for Rs.10,000 and a lemon owner will part ways with Rs.6000. Buyer not having information about types will be willing to pay an average price i.e. Rs8000. Cherry owners will not sell their cars at this price. This is how lemons will drive out cherries from market. Hence markets will collapse.
But the markets are still working. Then what explains that?
The theory above is based on the assumption that sellers have no credible disclosure technology. This means that there is no way for cherry owners to signal to the buyers that the car they are trying to sell is a good one. In reality, many mechanisms have been set up to deal with this problem. And hence markets go on working.