Understanding Asymmetric Information as an Economic Problem

 Asymmetric information means that one party in a transaction has more knowledge
about the quality of a product than the other party.

 The asymmetric information problem differs from uncertainty in that under uncertainty, both
parties have equal information and can calculate the expected value of the outcome.

 The economic problem with asymmetric information is adverse selection. Adverse

selection means that buyers try to protect themselves from poor quality by paying a lower
price than the expected value of a quality product, and thus driving high-quality products off
the market.

On the left you can see used cars, some of

which are gems (high-quality cars) and lemons
(poor-quality cars). If buyers and sellers both
have perfect information, the gem will sell
somewhere between the buyer’s and the
seller’s reservation prices. Economic value is
created.

Lemons create no economic value and will not

be sold at all.

Assume that 50% of cars are gems and 50%

are lemons, but neither buyers nor sellers
know which ones are gems or lemons.
In this uncertain situation, buyers and sellers
would determine the expected value of the
transaction.

A risk-neutral buyer would pay up to $5,000

for a car. A risk-neutral seller would find
expected value of

½ x $8,000 + ½ x $0=$4,000.

The car would sell somewhere between

$4,000 and $5,000 .
Under asymmetric information the seller
knows which cars are gems and which are
lemons.

With asymmetric information, the market

for high-quality vehicles disappears because
buyers understand that the seller knows which
vehicles are gems and which are lemons. This
problem is called adverse selection.

To protect themselves against lemons, buyers

are not willing to pay a high enough price to
attract the gems, so sellers withdraw the gems
from the market. The result is that only
lemons appear on the market.

There are some ways to solve the problem of

asymmetric information.

One solution is “lemon busters.” These

businesses are services that buyers hire to
inspect products for quality.

Another solution is guarantees from sellers

regarding the quality of the product.