Adverse selection is a huge problem that often exists in the market, it is when the buyers or the sellers hide relevant information from the other party to gain benefits. Whereas the lemons problem refers to the problems that arise when the buyers fail to estimate the premium price of the product and set an average price to escape such problems. Both scenarios will be discussed in depth in this article. We shall also discuss the consequence and solutions for such problems.
What is Adverse Selection ?
Adverse selection occurs when the sellers do not provide the buyers with complete and accurate information about the product. In other words, we can say that there is asymmetric information in the market. When people participating in the market do not have complete information, they cannot make rational and calculated decisions and as a result, they cannot estimate the accurate price of the goods. Asymmetric information is also known as information failure, a case in which one participant in the market has more information about the goods than the other. In a perfect case scenario, we assume that the sellers provide honest information about the product to all the customers or vice versa, this is known as symmetric information.
Understanding Adverse Selection and the Lemons Problem in Economics
Also Read: Understanding Prospect Theory in Behavioral Economics with Example
Sometimes the sellers do not provide accurate information about the product to the buyers due to which the customers do not get precise information to make rational decisions. This is a phenomenon that occurs from both participating sides of the trade. In some special cases such as with life insurance, the buyers tend to have more information such as their health conditions or any sort of risk involved in their jobs. When the clients have more information than the insurance company, the chances are higher of them collecting the insurance money as they are more exposed to life-threatening situations than normal clients.
Example of Adverse Selection
The most common example of adverse selection is health insurance, often it is the case that the person obtaining the insurance policy hides their diseases or addictions to gain normal insurance. Most smokers also hide their smoking habits in order to get more benefits even though they are at a larger risk of getting lung diseases or even cancer than normal people. As smokers are more likely to get sick, they are asked to pay higher premiums for insurance, and therefore they try to register as nonsmokers. By hiding this fact, the clients provide asymmetric information to the insurance company and lead them to make uninformed decisions.
What is the Lemons Problem ?
The lemon problem is concerned with the very important issue of deciding the actual price of the asset or goods in the absence of symmetric information. This problem was first highlighted in a research paper in “Quarterly Journal for Economics” under the name “The market for lemons” in the year 1970. This article was written by George A. Akerlof. He explained the phenomena of the lemons problem that asymmetric information often leads to failure of the market. As the buyers cannot estimate the actual price of the product and are at risk of overestimating or underestimating the price, they are more reluctant to sell their product.
On the other hand, if the lemons problem becomes common then consumers will not offer high prices for any products for the fear of being taken advantage of and hence, even honest sellers will not be offered well for their products, and they will not want to sell their goods. This upsets the supply and demand equilibrium in the economy.
Example of the Lemons Problem
The most common example of lemons problems that is also mentioned in the article “the markets for lemons” is of trade of used cars. It is often the case that the sellers hide crucial information about the vehicle and try to hide the faultiness of the vehicle by many different means. It becomes very difficult for the buyer to point out the faulty elements if they are not professionals. Hence, this confuses all the potential buyers and makes it hard for them to predict its actual price.
Therefore, to avoid being tricked an average price is set for the vehicle. This average price lies somewhere between the asked price and the premium price. This scenario creates a chance for the buyers to have some safety and makes them less vulnerable to buying a lemon. This solution can go both ways for the seller. If some cases the average price is still more than what the seller could have received if the buyer had accurate information about the vehicle. But in other cases, it is very disadvantaging for the seller because the average price determined by the buyers may be less than the actual value of the car.
Consequences of Adverse Selection and the Lemons Problem
The biggest impact or consequence of lemon’s problems and the problem of adverse selection is market failure. Having asymmetric information in the market can upset the market equilibrium and make trade difficult. These problems do not only upset the car market but also prevail in the stock market. For example, a manager of a company may sell a greater number of shares in the stock market, if he realizes that the price of the share is overvalued in the stock market. This can come as a huge disadvantage for the investor who may buy the stock at a high price and end up losing their money.
On the other hand, the seller of the car may be aware of the defects in the vehicle but trick the customer into buying it at a higher price point by not disclosing all the relevant information. Another big consequence can have been on the health of the consumers. For example, if a medication company sells its medicines without disclosing all the side effects of the product, then it can prove to be highly dangerous or even life-threatening in some cases.
Solution of Adverse Selection and Lemons Problem
The problem of lemons and adverse selection exists among both sellers and buyers. The main solution that Akerlof suggested for this problem was offering strong warranties, this will save the buyers from getting tricked by the sellers. Another modern solution that is now available for overcoming this problem is researching the product on the internet. These days many websites and applications provide investors with accurate knowledge and insight about stocks. Getting informed about an asset has become much more possible and faster for consumers due to modern technology and a strong bridge between sellers and buyers.
Conclusion
To conclude adverse selection and the lemons problem can be very dangerous for the overall market. Asymmetric information can make it difficult for buyers and sellers to trade in the market and set a fair price for the product. Not having proper and complete knowledge of the product exposes the buyers to the risk of making irrational decisions. Several modern ways offer a solution to such problems. There are also some government laws and regulations in many countries that ensure the protection of customers and force companies to provide accurate information to all consumers.