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Asymmetric Information and Market for Lemons

Updated on May 14, 2016
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IRSHAD CV has been a student in Economics. Now he is doing Masters in Economics. He completed B.A. Economics from the University of Calicut.

In secondhand market, sellers know more than the buyer about the quality of the product.
In secondhand market, sellers know more than the buyer about the quality of the product. | Source

Introduction

Human beings are playing their life with the instrument of information. As a behavioral science, information on various aspects is very relevant for economic analysis to consider the role of information. Almost all of the foundational ideas of economics are based on a perfect market system, since economists believe that it could bring a better economic condition. Under a perfect competitive market system, it is assumed that, all the economic agents (consumers, sellers, producers etc) have perfect knowledge about their economic interventions. Thus perfect competitive market destroys all the possibilities for exploitations and unethical practices.

When we look at many economical issues, we can see that, each issue is covered with multilevel aspects. Thus the study of various aspects of an issue is significant. When social scientists analyze issues by looking from multilevel views, the information and its management can’t be neglected. Today each of the economic agents wants information about prices, quantity, quality, return from investment, profit and capital variations it is known to all that, there is no perfect competitive market in the world. So there arise the issue of asymmetric information and which causes for the unethical practices as well as exploitations in the economy. By meaning, asymmetric information refers to a condition of lacking of knowledge among different economic agents on a particular good or service. Sometimes, a particular party may have more knowledge than the opponent party while making transactions. So there is a possibility for exploitation and if so it will surely lead to the failure of market mechanism.

Buyers can evaluate the quality of the products only after using it for a while.
Buyers can evaluate the quality of the products only after using it for a while. | Source

The Cost of Asymmetric Information

Unlike a perfectly competitive market, other types of markets are creating costs either directly or indirectly to some parties. Very often, here asymmetric information creates such exploitations. Some of the illustrations can be used to prove such type of market failure or generate costs.

The existence of asymmetric information in insurance market is very often. Insurance market mainly consists of two economic agents, insured persons and insurance companies. Insurance may be based on certain terms and conditions and which aims the protection of interests of both the agents. Here the most valuable information is the health condition of the people who are going to take insurance. But generally, insurance market experiences the prevalence of asymmetric information since the insured persons have more knowledge than the insurance company about the health status. Sometimes, fake medical documents may used to fool the insurance company. In fact, there exists higher probability for the market failure in the insurance market.

Another real case of the existence of asymmetric information is with the labor market. There will be employees and employers. Here the matter is associated with the productivity of workers. The level of production capacity will be different from worker to worker. But only each employee knows more about their own potentiality and productivity. So the availability of information regarding the workers; ability will be different to employees and employers. So the employment market or the recruitment process may become failure because of asymmetric information. In modern corporate world, employment market is dealing through employment agreements. Thus the prevalence of asymmetric information may lead the labor market into labor contract issues and other types of legal issues. The cost of it will be much higher especially to recruiting companies.

A common case of asymmetric information can see in general commodity market. There will be two agents, consumers and sellers. The availability of information regarding commodities such as quality, price etc may be different to each of these agents. Generally sellers have more knowledge about commodities than the consumers. Very often, consumers can evaluate the quality of commodity after consumption. At the same time producers or sellers know more about the commodity and its quality. This type of asymmetric information may create burden on consumers. In certain cases, producers may offer warranty or guarantee services for the commodities. But it can only seen in the commodities produced by reputed companies. From the view of consumers, there type of services enhances the confidence on the commodities. In fact, a considerable amount of asymmetric information can be seen in the general commodity market.

Here, we shall focus on the economics of information, and the theory of market for lemons.

George Akerlof (Nobel laureate in Economics Science) has studied more on secondhand markets.
George Akerlof (Nobel laureate in Economics Science) has studied more on secondhand markets. | Source

Are secondhand commodity markets provides quality products?

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Market for Lemons

The idea of market for lemons was developed by a Nobel Laureate in Economic Science, George Akerlof. It is based on the analysis of asymmetric information in the second hand goods market. He used secondhand market of cars. Suppose you bought a car by spending $24000. After two-three weeks you changed your decision with the first car. You have no complaint with the quality of the car. But now you just want to change the brand as a part of your prestige. Then you approached a secondhand market for selling your car. Here the market will be under the condition of asymmetric information. The seller (you) know the actual condition and quality of the car since the seller driven it for a while. The seller expects a price of at least $22000since it has good quality, not used more and the seller is also able to transfer the benefits of guarantee and warranties. Now analyzing the same situation from the view point of a buyer, they may think that it is a secondhand car so it quality can’t be assured as like a first quality car promises. So he will be ready to buy the car only at an average level of price in the secondhand markets. So he will be ready to buy it only at a price of $18000 to 20000. In the similar case, the prevalence of asymmetric information may lead to the underestimation of the price and quality of the commodities. Now the theory can also be analyzed based on a secondhand market where large number of commodities is exchanged.

Suppose there are two types of cars in a secondhand car market. One group is good quality cars and the other group- is b low quality cars. Since it is a secondhand market, people will be ready to pay only an average price for the cars. The prevalence of asymmetric information causes to the under estimation of good quality cars and over estimation of low quality cars. Further, the expectation of price for good quality cars will be higher. This situation will force the sellers of good quality cars to withdraw from the market. So supply of cars will be lower and the price will also go down since only low quality cars are available. Now some sellers who are selling comparatively good quality cars than the very low quality cars will also be encouraged to withdraw from the market. In fact, in this secondhand market, asymmetric information created every problem. The low quality cars destroyed the availability of good quality cars in the market.

Conclusion

Market for lemons is one of the examples of a market system where asymmetric information prevails. Simply, the asymmetry in the availability of information regarding a commodity among different agents creates many problems. As mentioned above, it may sometimes lead to the overvaluation or undervaluation of commodities. That means asymmetric information may lead to the failure of market mechanism.

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    • Matt Easterbrook5 profile image

      Matthew A Easterbrook 12 months ago from Oregon

      Great article and it totally makes since from an economic stand point. I also enjoyed the market for lemons approach for second hand goods. This is a huge market for sure. Thanks for writing this interesting hub article.

    • BlossomSB profile image

      Bronwen Scott-Branagan 12 months ago from Victoria, Australia

      Can a competitive marketing system ever be truly perfect? I wonder - but I enjoyed reading your article, it was interesting.

    • Venkatachari M profile image

      Venkatachari M 12 months ago from Hyderabad, India

      Very interesting and intellectual discussion on asymmetric information market and the Market for Lemons. You clearly described how buyers and sellers are at a loss in such conditions. As regarding the question asked by Blossom, I think it is never possible to have a perfect competition market in this world.

    • icv profile image
      Author

      IRSHAD CV 12 months ago from India, Kerala

      @ Thanks Matt Easterbrook5 for reading and leaving a comment. Secondhand markets are actually important part of any economy even they are not considering into account while counting national income.

      @Thanks Blosson SB for your comment. Madam, in economics perfect competitive market is one of the markets among many forms. It does actually not exist in the world. Almost all the foundations of economic theories are based on certain assumptions to make and see the society in a better position. Perfect competitive market is one among them and where we assume that there exists perfect knowledge among different economic agents. Then the economy will be in a better position with lower exploitations and unethical practices. So it indirectly focuses on the importance for providing financial literacy among people to make the market function at its best. So to your question my answer would be, we need to do more to become our economic and social systems better.

      Venkatachari M for your comment. We need more co-ordination to become our systems better. A perfect condition may not possible, but we may attain something closer to that by providing education and skills to the people along with better functioning political system

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