Asymmetric Information – Lemons Problem – Implications on business and finance

In Economics, Asymmetric Information refers to decision in transactions, when one party has more information than the other party involved in the transaction. This imbalance in access to information creates an information divide, which may lead to market collapse.

In this article, we would be discussing the impact of asymmetric information on markets and finance leading to problems of adverse selection.

Small Lemons - big problem

 

Lemons Problem – One of the prominent papers written on asymmetric information is by George Akerlof on “The Market for Lemons: Qualitative Uncertainty and Market Mechanism”. The main point of the paper was how asymmetric information creates the problem of adverse selection.

 

STRUCTURE:

There is a market of potatoes with good and bad potato sellers. (GROUP OF POTENTIAL TRANSACTIONS)

The buyer of potato cannot identify between good and bad potatoes. (INFORMATION ASYMMETRY) This might not be a practical assumption in case of potatoes but might stand well for more complex commodities and financial instruments.

PROBLEM:

Since buyer cannot identify the bad potatoes, they would be willing to pay only average price for the potatoes. Let’s say following are the prices:

Price of good potatoes – Rs. 10 per kg

Price of bad potatoes is Rs. 5 per kg

Thus the buyer would be willing to pay around Rs. 7 or 8 per kg for potatoes. This is a common scenario, isn’t it? If we know that the price charged for a specific product is not up to the quality desired, we generally would be willing to pay only an average price for that product (average of the bad and good).

However this average price is very attractive for bad potato sellers (potato value is lower than the market price that is being offered) and not at all satisfying for good potato sellers (value of potato is higher than market price being offered). This is called adverse selection. The market is selecting and incentivizing bad potato sellers.

Now since the price offered to bad potato is higher than the value, the supply of bad potato will increase, leading to more bad potatoes than good potatoes in the market. Given this scenario all the bad potato sellers would be willing to sell their potatoes, as they are getting a good price for their relatively bad quality of potatoes. This will make potato buyers more suspicious of the quality of the potato and they will feel that a randomly selected potato has a higher probability of being bad. This will further reduce the offer price from the buyers.

Going forward the market price will be increasingly unfeasible for good potato sellers and remaining unsatisfied they will start packing their shops. Very soon the customers will lose the trust as many of the bad potato sellers would now be willing to sell the product at the price that is being offered. So the buyers will start leaving the market ultimately leading to the collapse of the market. The main reason behind the breakdown of the market was asymmetry of information. The potato buyers did not have adequate information to distinguish between good potatoes and bad potatoes, ultimately leading to collapse of the market.

The idea of lemons problem is also extendable to area of corporate finance. Personally I find it equally difficult to buy a stock and potato, but logically speaking since there are far many complex factors that determine stock quality than potato quality, so let us assume for a minute that buying a stock is complex than buying potato (no offences to housewives)

Putting the same analogy, if investors cannot determine the value of the firm before they buy the equity, they would be willing to pay only an average price for the stock (equity) of the firm. Given the price is average, selling equity in the market for bad firms is far more incentivizing and attractive than it is for the good firms. Hence more and more bad firms would be offering equity in the market (Adverse selection). Very soon the investors will become suspicious and if they are offered equity than it must mean that the firms’ value will be below average. Hence investor will no longer be willing to pay average price for the equity, which will ultimately lead to collapse of market with no transactions taking place.

Practically speaking, in real life scenarios we don’t see efficient markets, rational buyers and many a time buyers can distinguish between good value stocks and bad value stocks, using the understanding of valuation techniques or equity research reports. Thus what can be deduced is that companies with more R&D based activities which create more information asymmetry between investors and company’s existing owners have a higher probability or reason of high owners’ or promoters stake. This is one example that explains the reasoning in the real life scenario.

Can you find some more real-life examples (business or non-business) justifying the lemons problem – Asymmetric information?

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George Arthur Akerlof (born June 17, 1940) is an American economist and Koshland Professor of Economics at the University of California, Berkeley. He won the 2001 Nobel Prize in Economics (shared with Michael Spence and Joseph E. Stiglitz). His father was Swedish and his mother a Jewish/German-American.

George Akerlof at Berkeley, 1966

Akerlof is perhaps best known for his article, “The Market for Lemons: Quality Uncertainty and the Market Mechanism”, published in Quarterly Journal of Economics in 1970, in which he identified certain severe problems that afflict markets characterized by asymmetrical information.

 

 

 

Good day,

Anshum Saxena

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More on ‘Lemons Problem’

Writing the “The Market for Lemons”: A Personal Interpretive Essay by George Akerlof

Asymmetric Info Models of Capital Structure

George Akerlof and Lemons Problem

 

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