256 CHAPTER 9 Transactions Costs, Asymmetric Information, and the Structure of the Financial System

A lemon,
or a car that has been poorly maintainedby, for instance, not having its oil changed
regularlycould have damage to its engine that even a trained auto mechanic might
have difficulty detecting. The prices that potential buyers are willing to pay for used
cars will reflect the buyers lack of complete information on the true condition of the
cars. Consider a simple example: Suppose that you are in the market for a used 2008
Honda Element. Suppose also that you and other buyers would be willing to pay
$15,000 for a good, well-maintained car but only $7,000 for a lemon. Unfortunately,
you cannot tell the lemons from the good cars, but you have read an online report that
indicates that about 75% of used 2008 Elements are well maintained, while the other
25% are lemons. In Chapter 4, we introduced the concept of expected return, which is
calculated by adding up the probability of each event occurring multiplied by the value
of each event. In this case, we can calculate the expected value to you of a 2008 Honda
Element you choose randomly from among those available for sale:
Expected value = (Probability car is good) * (Value if good)
+ (Probability car is a lemon) * (Value if a lemon).
Or,
Expected value = (0.75 * $15,000) + (0.25 * $7,000) = $13,000.
It seems reasonable for you to be willing to pay a price for a Honda Element equal
to the expected value of $13,000. Unfortunately, you are likely to run into a major
problem: From your perspective, given that you dont know whether any particular car
offered for sale is a good car or a lemon, an offer of $13,000 seems reasonable. But the
sellers do know whether they are selling good cars or lemons. To a seller of a good car,
an offer of $13,000 is $2,000 below the true value of the car, and the seller will be reluctant to sell. But to a seller of a lemon, an offer of $13,000 is $6,000 above the value of
the car, and the seller will be happy to sell. As sellers of lemons take advantage of knowing more about the cars they are selling than buyers do, the used car market is subject
to adverse selection: Most used cars offered for sale will be lemons. In other words,
because of asymmetric information, the used car market has adversely selected the cars
that will be offered for sale. Notice as well that the problem of adverse selection reduces
the total quantity of used cars bought and sold in the market because few good cars are
offered for sale. From Akerlof s analysis of adverse selection in the used car market, we
can conclude that information problems reduce economic efficiency in a market.
To reduce the costs of adverse selection, car dealers act as intermediaries between
buyers and sellers. To maintain their reputations with buyers, dealers are less willing to
take advantage of private information about the quality of the used cars that they are
selling than are individual sellers, who will probably sell at most a handful of used cars
during their lifetimes. As a result, dealers sell both lemons and good cars at their true
values. In addition, government regulations require that car dealers disclose information about the cars to consumers.