Question 1009 lemons problem, asymmetric information, adverse selection
Akerlof’s 1970 paper ‘The Market for "Lemons": Quality Uncertainty and the Market Mechanism’ provides a famous example of asymmetric information leading to market failure. This example is commonly known as the ‘Lemons Problem’. Imagine that half of all second hand cars are:
- Lemons worth $5,000 each. Lemons are bad second-hand cars with hidden faults that only the seller knows about; and the other half are
- Plums worth $10,000 each. Plums are good second-hand cars without faults.
Car buyers can’t tell the difference between lemon and plum cars.
Car sellers know whether their car is a lemon or a plum since they’ve driven the car for a long time. However, plum car owners cannot prove their cars’ higher quality to buyers. Also, lemon car owners are known to dis-honestly claim that their cars are plums.
What will be the market price of second hand cars?