Information Asymmetry
What happens when we have incomplete information
Back in 2014 I bought my first used car, a 2005 Volkswagen Golf. I looked up the book value online, and the price the dealer asked for was in line with that number, but there was really no way for me to know if there were any problems with the car. This situation, where one party of a transaction has all of the information about a product, and the other party has very little or no information, is known in economics as an information asymmetry problem.
The lemon market
Economist George Akerlof studied what happens in a market with high information asymmetry, and his thesis is as follows. Let’s say that in the market for used cars, some fraction of cars are “lemons”: cars that are in bad condition due to some serious issues such as engine problems. Then, buyers will demand a discount compared to the car’s book value, compensating them for the risk of buying a lemon. Used car prices will drop.
Car owners on the other hand know the value of their car: owners of high-quality cars are not willing to accept a discounted price and will leave the market, which will cause a further increase of the lemon fraction. This in turn will cause a further decrease of the price buyers are willing to pay, given that they face an even greater risk of buying a…
