FIN 444Asymmetric InformationA situation where one party to a market transaction has much more information about a product or service than the other.
Moral Hazard ProblemThere is a tendency of one party to a contract to alter his/her behaviour in ways that are costly to the other party .
Adverse Selection ProblemInformation known by the first party to a contract is unknown to the second and, as a result, the second party incurs major costs.
Used Cars: The Market for “Lemons”A new car loses much of its market value as the buyers drives it off the sales lot. The question is, why?
One explanation relates to inadequate information about used cars, some are good and some are “lemons” of poor quality.
Consumers cannot distinguish the good from the defective, so a single price emerges for used cars, which roughly reflects the average-quality car.
This leads to an adverse selection problem. Owner of lemons have an incentive to sell their cars because the average price is above that for the low-quality car they own.
Therefore, there will be proportionately more low-quality cars offered than good-quality cars whose owners hold onto them rather than offer them at the average-quality price.
At the extreme, only lemons would appear on the used-car market, but even without the extreme, this theory offers one explanation of the pricing of used cars.