A car really is a peach, they cannot

A market is a place in which buyers and sellers meet. The secondhand cars are the market that I will be describing. The goods being traded are used cars- “peaches (good quality ones) and “lemons” (cars which frequently break down and require a lot of maintenance). The participants involved are the buyers and sellers of the cars. One characteristic is that there’s an information gap between the buyers and the sellers. Sellers tend to have more knowledge than the buyers on the quality of the cars being sold leaving the buyers to guess. This is known as asymmetric information. As a result of this, it leaves the buyers in a disadvantaged position as they cannot spot the quality difference indicating that they may pay a high price for the car and not get the car they wanted which is a peach. There is a high percentage that most of the cars being sold are lemons because sellers of the peaches don’t want to offer a low price. This help explains the concept of adverse selection, as bad quality cars push the good quality cars from the market. Leaving the market to unravel. Potentially, there might not be any market because there will be no buyers willing to buy lemon cars for a high price. The market doesn’t work as well as it should; second-hand cars tend to be cheap and of poor quality. Sellers with good cars want to hold out for a good price, but because they cannot prove that a good car really is a peach, they cannot get that price and prefer to keep the car for themselves. We might expect that the sellers would benefit from their inside information, but in fact, there are no winners: smart buyers simply don’t show up to play a rigged game. Akerlof showed that none of those value-creating trades happens because the buyers will not buy without proof, and the sellers cannot offer proof. If buyers and sellers were both ignorant about whether a car was a lemon or a peach there would be no problem. A deal will be a strike without any complications. Asymmetric information can make agreement becomes impossible and it also destroys perfect markets. This lack of information prevents efficient transactions leading to market failure. The expected amount of equilibrium depends on the quality of the seller’s information relative to the buyer’s, and hence the degree of information asymmetry between the two sides of the market.  Scenario example: Suppose that potential sellers are willing to sell for £1000. Potential buyers are willing to pay up to £1500 for the lower quality car. The owners of peaches are willing to accept £3000 for their better quality cars and potential buyers are willing up to £4000 for one. The buyers know that half the cars are lemons and half are peaches. So there’s risk of getting a lemon when you really want to buy a peach. As a result, buyers would only be willing to pay around the mid-point between the most they would for a lemon and the most they would pay for a peach: ½ (£1500 +£4000)= £2750The sellers of lemons would be delighted to get this price for their defective cars. But this wouldn’t be acceptable to sellers who know their cars are of good quality and are actually worth a lot more. It would encourage sellers of poor quality whereas sellers of higher quality ones would be discouraged thus potentially exiting the market leaving only the lemons in the market explaining the adverse selection theory. An unusual strategy used is when the seller provides a signal to the buyers by providing a warranty. The potential cost of a warranty to the seller is interpreted by the buyer as a signal about the true quality of the car. Buyers don’t have any expertise, its difficult for them to independently verify whether the car with a warranty is any better than the car without one. If the seller knows that the car has had a good track record, then he can be confident about offering a warranty because of the chances of coming back to him demanding costly repairs if quite low. Therefore, offering a warranty when a car is in good condition will unlikely to cost anything. Buyers will be more inclined to believe sellers because they know they want to increase profit and will not want to pay the repair bills if he can possibly avoid it.