:max_bytes(150000):strip_icc()/row-of-pre-owned-cars-for-sale-173028514-c037042aa60a4acdb722086e98bc9e50.jpg "The Problem of Lemons: Buyer vs. Seller")
What Is a Lemon?
The theory of lemons was put forward in a 1970 research paper in The Quarterly Journal of Economics, titled “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” written by George A. Akerlof, an economist and professor at the University of California, Berkeley. A lemon problem arises regarding the value of an investment or product due to asymmetric information possessed by the buyer and the seller.
Key Takeaways
- The lemon problem refers to the issues regarding the value of an investment or product due to the asymmetric information available to the buyer and seller.
- The theory was described by George A. Akerlof, an economist, who presented his ideas in a research paper titled “The Market for “Lemons”: Quality Uncertainty and the Market Mechanism.”
- “Lemon” is a slang term for a vehicle with many problems and defects that negatively impact its utility and worth.
Asymmetry of Information
Nobel Prize recipient George Akerlof examined the used car market and illustrated how the asymmetry of information between the seller and buyer could cause the market to collapse, getting rid of any opportunity for profitable exchange and leaving behind only “lemons,” or poor products with low durability that the buyer purchased without sufficient information.
Asymmetrical information means that buyers and sellers don’t possess equal information required to make an informed decision regarding a transaction. The seller or holder of a product or service usually knows its value or at least knows whether it is above or below average in quality. Potential buyers, however, typically lack this knowledge and can only rely on the seller’s information.
Used Car Example
Akerlof’s example of the purchase of a used car noted that the potential buyer of a used car cannot ascertain the value of the vehicle. Therefore, they may be willing to pay no more than an average price, which they perceive as between a bargain price and a premium price.
Adopting such a stance may offer the buyer financial protection from the risk of buying a lemon. Akerlof pointed out, however, that this stance favors the seller since receiving an average price for a lemon would still be more than the seller could get if the buyer knew that the car was a lemon.
Ironically, the lemons problem creates a disadvantage for the seller of a premium vehicle since the potential buyer’s asymmetric information—and the resulting fear of getting stuck with a lemon—means they are unwilling to offer a premium price for a vehicle of superior value.
The U.S. “lemon law” that sets regulations for consumer products covered by written warranties is found in Title 15, Chapter 50 of the U.S. Code, in Sections 2301-2312, also known as the Magnuson Moss Warranty Federal Trade Commission Improvements Act.
Protection From Lemons
The lemons problem exists in the marketplace for consumer and business products and investing, related to the disparity in the perceived value of investments between buyers and sellers. The lemons problem is also prevalent in the financial sector, such as the insurance and credit markets. For corporate finance, a lender has asymmetrical and less-than-ideal information regarding the actual creditworthiness of a borrower.
Akerlof proposed strong warranties to thwart the lemons problem, as they can protect a buyer from any consequences of buying a lemon. Another solution Akerlof did not know when he wrote the paper in 1970 is the explosion of readily available information disseminated through the Internet. Information services such as Carfax help buyers feel more confident by providing a vehicle’s history.
What Is the Lemons Theory?
The basic tenet of the lemons principle is that low-value cars force high-value cars out of the market because of the asymmetrical information available to the buyer and seller of a used car. This is primarily because a seller does not know the value of a used car and, therefore, is unwilling to pay a premium on the chance that it might be a lemon. Premium-car sellers are not willing to sell below the premium price, so only lemons are sold.
What Percentage of New Cars Are Lemons?
It is estimated that each year, approximately 150,000 cars (1%) are considered lemons; however, it is believed that the number is probably higher due to people not reporting defective cars or not being aware of the extent of the defects.
What Are Lemon Laws?
Lemon laws help provide a solution and protection for purchasers of cars and other goods. They implement compensation programs for buyers when the products fail to meet quality and performance standards.
The Bottom Line
“Lemon” commonly refers to a vehicle with defects that negatively impact its worth. The lemon theory was described by Nobel Prize recipient, George A. Akerlof, an economist, who noted the asymmetric information available to the buyer and seller when purchases are made in the marketplace.