In the study of markets, we ordinarily assume that the buyers and sellers both are perfectly informed about the quality of the goods that are sold in the market. This assumption can be accepted as realistic if it is easy for them to verify the quality of a good.
In that case, the prices of the goods would simply reflect the quality differences. But there are certainly many markets in the real world in which it may be very costly, or even impossible, to have accurate information about the quality of the goods being sold. For example, the labour market.
In economic theory, it is generally assumed that labour is a homogeneous service—every worker has the same “kind” of labour and supplies the same amount of effort per hour worked. This is clearly a drastic simplification. In the real world, it is very difficult for a firm to determine how productive its employees are.
To obtain accurate information about quality is a problem also in the markets for consumer goods. When a consumer buys a used car, it may be very difficult for him to determine whether it is a good car, called a “plum” car or a bad car, i.e., a “lemon”.
However, the seller of the used car has probably a pretty good idea of the quality of the car. Here the information is asymmetric between the buyers and the sellers. We shall see that this asymmetric information may cause significant problems with efficient functioning of the market.
The Market for Lemons:
Let us consider a market where the demanders and suppliers have different information about the quality of the goods being sold. Let us consider a market where 100 people want to sell their used cars and 100 people want to buy used cars.
Let us suppose that everyone in the market knows that 50 cars are “plums” and 50 are “lemons”. The present owner of each car knows its quality, but the people who want to buy the car, do not know whether any given car is a plum or a lemon.
Let us now suppose that the owner of a lemon is willing to sell his car at Rs 50,000 and the owner of a plum is willing to sell his car at Rs 1,00,000. On the other hand, the buyers of the car are willing to pay Rs 1,20,000 for a plum and Rs 60,000 for a lemon.
Now, if it is easy to verify the quality of the cars, there will be no problems in the market. For, then, the lemons will sell at some price between the sellers’ price, i.e., Rs 50,000 and the buyers’ price, i.e., Rs 60,000, and, in the same way, the plums will sell at some price between Rs 1,00,000 and Rs 1,20,000.
But, if the buyers have no way to know the quality of the car, then they have to just guess about the quality and about how much should be paid for the car.
If a car is equally likely to be a plum or a lemon, then the simplest assumption about the guess would be that a typical buyer would be willing to pay the expected value of the car which, in the present case, would be equal to 1/2 x 60,000 (Rs) +1/2 x 1,20,000 (Rs) = 90,000 (Rs).
But, obviously, only the owner of a lemon will be willing to sell his car at the price of Rs 90,000. Because, he offers his car at a price of Rs 50,000 and the buyer is willing to pay much higher an amount which is Rs 90,000.
However, the owner of a plum will not be willing to sell his car at the price that the buyer is willing to pay. For he wants considerably more, Rs 1,00,000, than what the buyer is offering to pay, which is only Rs 90,000. In other words, at the price of Rs 90,000, only the owners of lemons will be willing to sell their cars.
But if the buyer was certain that only the owners of lemons are willing to sell their cars, he would not be willing to pay Rs 90,000 for a car. Actually, the equilibrium price in the market, under the circumstances, would be somewhere between Rs 50,000 and Rs 60,000.
Therefore, in this market of asymmetric information, none of the plums can get sold although the price (Rs 1,20,000) the buyers are willing to pay for a plum exceeds the price at which the sellers are willing to sell (Rs 1,00,000). It is a case of market failure.
Now, what is the source of this market failure. The problem is that there is an externality between the sellers of good cars and bad cars. When an individual tries to sell a bad car, the buyers’ perceptions of the quality of the average car on the market is affected.
This lowers the price they are willing to pay for the average car, and thus hurts the interest of the people who are trying to sell good cars. It is this externality that causes the market failure.
Thus, the cars that are most likely to be offered for sale are those that people want most to get rid of. The very act of offering to sell something sends a signal to the prospective buyer about its quality. If too many low quality items are offered for sale, it makes it difficult for the owners of high quality items to sell their products.