Name:​ Aditya Sudini

Assignment:​ Fall 2019 incomplete research paper on asymmetric information

Professor: ​Ergin Bayrak

Asymmetric information as a source of market failure

The purpose of this paper is to explore the market failure caused by Asymmetric

information starting at the landmark article, “Market for lemons: Quality uncertainty and the

Market mechanism”, by George Akerlof. For here, the paper will discuss other economists'

points of view, and their contribution to the literature on the subject.

It was Thomas Hobbes who identified that man is at his core, a selfish creature.

Meaning that the decisions that he usually makes will be in his self-interest, even if the

interests of the group are sacrificed as a result. This idea that man is inherently selfish, is

essentially at the core of the market failure identified by George Akerlof. In his 1970 article,

Market for lemons: Quality uncertainty and the Market mechanism, Akerlof discusses the

role of asymmetric information and dishonesty in causing market failure1. A market failure is

a scenario in which there is inefficiency in the free market leading to below optimal

production or consumption of a good. Either too much or too little of a good will be

produced.

The problem of asymmetric information arises when the buyer or seller of a good or

service has some extra knowledge about it than the other party. This would pertain to

information regarding quality of the product, how long the product would last, the

1
Akerlof, G. “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” ​Essential
Readings in Economics​, 1995, pp. 175–188., doi:10.1007/978-1-349-24002-9_9.
authenticity of the product and so on. The degree of asymmetric information may vary from

market to market, depending on the complexity of the goods. For instance, a fruit vendor

might have knowledge of the origin of the fruit and its handling before being sold, but the

buyer, to a large extent, can estimate its quality by observing its physical characteristics. In

this scenario, the extra information has little weight. However, the seller at an antique market

has information regarding the true quality and authenticity of a product that the buyer can

only come to know over time. In this scenario, the extra knowledge that the seller has, has

more weight. Akerlof discusses the problems that asymmetric information causes in markets

akin to the latter scenario.

In his paper, the discussion revolves around the used car market, wherein complete

knowledge of the quality of the car can only be gleaned over time. A prospective buyer can

never have as much knowledge about the quality of a used car, as its owner/seller. It takes

time to gain an understanding of a product as complex as a car, and the knowledge of its

quality is directly proportional to the duration of ownership. This means that a prospective

buyer of a used car cannot know about the true quality of the car. However, the buyer does

have the idea that some of the used cars are of good quality, “plums”, and some of them are

of poor quality, “lemons”. Since the buyer cannot know with certainty the nature of the car,

there is incentive for the seller to pose a lemon as a plum. Doing so, allows the seller to

receive a greater price than he should. This makes the buyer wary of being deceived. If we

assume that the fair price for a plum is $1000 and the fair price for a lemon is $500, the

buyer, not wanting to pay such a high price for a possible lemon, will attempt to pay a price

as close to $500 as possible. Sellers of lemons will gladly accept a price over $500, but the

sellers of plums will be unwilling to sell at such a low price. Similar to Gresham’s law, where

“bad money drives out good”, the lemons of the market drive out the plums since they sell for
the same price. As owners of plums leave the market, the average quality of products falls

and the market size shrinks until only the lemons remain.

In the hypothetical used car market with only lemons and plums, there is a clear

incentive for lemons to be sold. Therefore, there they are disproportionately put up for sale,

leading to “adverse selection”. In his discussion of adverse selection, Akerlof cites the case of

insurance. Here, there is asymmetric information on the side of the buyer (insuree) rather than

the seller (insurer). In the insurance market, the buyer of insurance has greater information

regarding his health problems, occupational hazards, habits etc. This means that the insurance

provider could potentially end up with higher than expected costs. From the insurance

company's point of view, everyone has the same average health. If they were to price the

policy based on the average cost of healthcare based on average health, a portion of the

market (the healthier people whose benefit is much smaller than the cost) will choose not to

buy insurance. Now, the average health of the remaining people has deteriorated, and the cost

of healthcare has gone up. Therefore, the cost of insurance is also higher. Once again, the

price of insurance is higher than the potential benefit for a portion of the market, who will not

choose to buy insurance. And in this way, there is no insurance sale at any price. Here,

adverse selection by the buyers (healthy people opting out of insurance, and unhealthy people

chasing after it) leads to a market failure wherein, there is no insurance available at any price.

On the other hand, with the introduction of group insurance (provided by employer), the

providers are doing their own adverse selection, as adequate health is a requirement for

employment. This means that those members of society who need insurance the most, are

most often the ones who do not have it.

The cost of dishonesty lies not only in the amount by which the buyer was cheated but

also in loss incurred as a result of the loss in legitimate business. This is especially true in
underdeveloped, or developing countries, where the probability of quality uncertainty is far

greater than in a developed country. There is greater heterogeneity in the goods available in

underdeveloped countries, compared to the homogenous nature of the same goods in a

developed country. In Akerlof's lemon market scenario, the important skill of a merchant is

being able to identify the quality of used cars. This skill of being to discern quality is

essential for production wherein it is necessary to be able to identify quality of inputs and

validate the quality of outputs. This is an important reason why a merchant might become an

entrepreneur. Many texts on development cite entrepreneurship as an important factor, and

some even refer to it as essential or central. Unfortunately, quality uncertainty impedes

entrepreneurship because the pay-off to trade is greater than being involved in production,

and furthermore, the greater the quality variations in a market, there is more entrepreneurial

effort and time that needs to be invested per unit output.

As can be seen from all three situations, whether it was lack of knowledge in the used

car market, adverse selection in insurance provision or dishonesty and quality uncertainty in

developing countries, they all stem from an asymmetry in information. Given the economic

costs of this issue, economists have extensively studied the problem and attempted to find

solutions for it. While the problem might stem from the buyer and seller not having the same

information, each problem is unique and might require a different approach to solving it. For

the most part however, economists will agree that as is the case for many sources of market

failure, the government must step in to either enforce a standard by which both parties gain

the knowledge they were previously oblivious to, or the government itself should take

responsibility for providing that additional information. For instance, in LMICs (Low and

Middle income countries), there is an issue of information asymmetry in the healthcare sector
2
. Unscrupulous providers gouge prices at the expense of quality. Unfortunately for the

patients, their lack of awareness prevents them from buying products elsewhere even if they

would be willing to pay higher prices for better quality. Here, since the benefits of the

purchase mostly accrue to the buyer (patient) rather than the seller (provider), there is a

greater need to reduce information asymmetry by which high quality products can be

adequately advertised as being so. In order to overcome this issue, buyers must be given

some kind of metric by which they can accurately determine the quality of their purchase. It

is difficult to achieve an efficient market for these kinds of goods without providers being

held liable. Usually in LMICs, enforcement of liability and other state regulations are usually

weak. In countries where the enforcement of liability is weak, there are alternatives such as

provision of services by the public sector including government regulations and industry

standards. Furthermore, the country might rely on international donors or outcome-contingent

contracts (where the seller does not receive payment until the outcome of the service is

certain.) It should also be noted that in times of catastrophe, even the poor will attempt to

purchase from a much higher cost provider in search of assured quality. The governments

should subsidise under these conditions, and furthermore find means by which they can

incentivise providers to ensure quality.

Unlike the potential solutions that Akerlof discusses in his paper, which mostly

pertain to a certification of some kind to ensure quality, another potential solution is

voluntary and/or mandatory disclosure3. For instance, if all insurance seekers voluntarily

divulged certain personal information that proved that they were low risk, then they would no

2
Dranove, David, and Ginger Zhe Jin. “Quality Disclosure and Certification: Theory and Practice.”
Journal of Economic Literature,​ vol. 48, no. 4, 2010, pp. 935–963., doi:10.1257/jel.48.4.935.

3
Benndorf, V. (2018). Voluntary Disclosure of Private Information and Unraveling in the Market for
Lemons: An Experiment. ​Games,​​9(​2), 23. doi:10.3390/g9020023
longer be required to pay expensive premiums. This means that insurance companies have

now incentivised the divulgence of information by which consumers can benefit by levelling

the playing field. In terms of mandatory disclosure, insurance companies now hire a panel of

medical professionals, to act on their behalf to ensure that the extra information that an

insurance seeker previously had, is no longer advantageous. Employers are also able to make

better informed decisions in regards to new hires. Since every job seeker has the ability to

share pertinent personal information, those refusing to do so will find it harder to find

employment. The downside to such voluntary disclosure is that it is done only in favourable

conditions. If the cost of revealing the information is greater than expected benefit, then

individuals are unlikely to divulge information. Therefore, there needs to exist, some

mechanism that compels the revelation of information. Such a mechanism exists in the

restaurant business, where mandatory inspections determine the safety of dining at that

establishment and establishments are also liable for failure to notify of health code violations.

Failure to pass the examination or notify of violations has heavy economic costs in terms of

loss of revenue and tarnished reputation. Additionally, car insurance providers now have

inbuilt GPS to help determine driving behaviour. Such mechanisms also help in closing the

divide caused by asymmetric information. Another economist, Gregory Lewis4, also looked

into disclosure in markets traditionally plagued with asymmetric information and adverse

selection. He studied online markets and found that the volume of trade was surprisingly

high. Most online markets today have requirements that compel credible disclosure and

contract compliance. With these requirements, sellers are incentivized to solve the

asymmetric information problem. Lewis however, points out that “if contracts are not

4
Lewis, Gregory. “Asymmetric Information, Adverse Selection and Online Disclosure: The Case of
EBay Motors.” ​SSRN Electronic Journal​, 2010, doi:10.2139/ssrn.1358341.
enforceable, they are meaningless; while if disclosures are costly, the resulting contracts may

be coarse and market efficiency may suffer.”

Returning to the market for lemons, a solution to potentially eliminate asymmetric

information in the used car market has come in the form of block chain storage of car

information5. The purpose of the platform is to store and provide prospective buyers with the

complete information about the life cycle of the car. The objective is to reduce information

asymmetry that previously favored sellers and enhance trust between buyers and sellers. The

benefit of the blockchain system as opposed to other car rating services is that individual

records are all linked together in one chain. The system has certain characteristics like

transparency, data integrity, and decentralized nature make it more trustworthy for the parties

involved in the transaction.

Building on the work of Akerlof, Fabian Herweg and Daniel Muller6 investigated the

used car market and found that 36,000 cars were sold every month on eBay motors. Akerlof

expected that in such markets, a very low volume of trade will occur. However, that is a

reasonably high number. According to Herweg and Muller, empirical investigations of used

car markets only discovered weak evidence of adverse selection. They believe that the

discrepancy between theoretical expectations and empirical observations is because of

overconfident buyers. They believe that this overconfidence is a result of a “noisy” signal

about the quality of the product. For instance, a short test drive does not always reveal the

true quality. The car may have been involved in an accident and cosmetically repaired. They

concluded that if buyers are sufficiently overconfident then all qualities of products end up

5
Zavolokina, Liudmila, et al. “How Can We Reduce Information Asymmetries and Enhance Trust in
‘The Market for Lemons’?” ​Information Systems and e-Business Management​, 2020,
doi:10.1007/s10257-020-00466-4.

6
Herweg, Müller. “Overconfidence in the Markets for Lemons.” The Scandinavian Journal of
Economics, vol. 118, no. 2, Wiley Subscription Services, Inc, Apr. 2016, pp. 354–71,
doi:10.1111/sjoe.12135.
getting traded. Therefore, the presence of overconfident buyers stabilizes the market, and

prevents a complete adverse selection outcome. However, this often means that rational

buyers are no longer participants in this market. Furthermore, the presence of overconfident

buyers incentivises the seller to make the signal obscure. Overall, there is a fall in welfare as

its increase due to increased probability of trade is offset by incentive to obscure signals.

In his paper, Akerlof discusses adverse selection, only one of the two main symptoms

of asymmetric information. Moral hazard, like adverse selection, leads to market failure. It

involves two parties getting into a “contract”, wherein one of the parties uses the existence of

asymmetric information to benefit in the transaction. For instance, a car mechanic might

recommend getting a more expensive piece of equipment or repair because you are not as

knowledgeable as him about cars. Some economists found that the usage of the word moral in

moral hazard makes the concept unclear. Matthey McCaffrey’s paper7, “The morals of moral

hazard: a contracts approach” discusses how the concept may be better defined to avoid

ambiguity. He takes issue with the fact that, “an ostensibly positive science describes an

economic problem in normative terms.” According to him, the morality of an action is

independent of whether the decision was economically rational. He said, “The rationality of

an action does not excuse it morally.” Given this confusion, he looks at it through the

enforcement of property rights and contracts. Property rights and contracts play a vital role in

determining the morality of an action. However, sometimes non specific terminology and

ambiguity of terms means that more information is needed to pass judgement on an action.

He concedes that while this approach may be used, its limitation lies in its requirement of

7
Mccaffrey, Matthew. “The Morals of Moral Hazard: a Contracts Approach.” ​Business Ethics: A
European Review​, vol. 26, no. 1, 2016, pp. 47–62., doi:10.1111/beer.12121.
well defined terms. He urges more research to be done in scenarios where it is too expensive

to write up contracts.

Asymmetry in information, and the subsequent uncertainty in quality are harmful to

any market. The ramifications of the inefficiencies in the markets can be debilitating. By

reducing or eliminating it, depending on the scenario, the provider or consumer is able to

make the best possible decision in those circumstances. By giving prospective buyers

complete knowledge about the lifecycle of a car, or reaffirming their confidence in the quality

of a garment because of the brand, there is substantial benefit to both consumer and provider.

The consumer is able to make an informed decision by which he/she will benefit far more

than by making a decision based on a lack of knowledge. The provider who is honest, and

fair will benefit from the trade, as his/her goods are more likely to be consumed. While there

are many ways in which the many asymmetries in information can be reduced, a mechanism

by which honesty is truly economically rewarded trumps it all. The issue of asymmetric

information only arises due to the benefit that a particular party gains from withholding

information. While it may be in man's nature to look out for his best interest, even if it means

sacrificing collective interest, as a society, we must strive to make honesty a core part of any

economic transaction.
Bibliography:

- Akerlof, G. “The Market for ‘Lemons’: Quality Uncertainty and the Market

Mechanism.” ​Essential Readings in Economics,​ 1995, pp. 175–188.,

doi:10.1007/978-1-349-24002-9_9.

- Dranove, David, and Ginger Zhe Jin. “Quality Disclosure and Certification: Theory
and Practice.” ​Journal of Economic Literature​, vol. 48, no. 4, 2010, pp. 935–963.,
doi:10.1257/jel.48.4.935.
- Benndorf, V. (2018). Voluntary Disclosure of Private Information and Unraveling in
the Market for Lemons: An Experiment. ​Games,​ ​9(​ 2), 23. doi:10.3390/g9020023
- Lewis, Gregory. “Asymmetric Information, Adverse Selection and Online Disclosure:
The Case of EBay Motors.” ​SSRN Electronic Journal,​ 2010,
doi:10.2139/ssrn.1358341.
- Zavolokina, Liudmila, et al. “How Can We Reduce Information Asymmetries and
Enhance Trust in ‘The Market for Lemons’?” ​Information Systems and e-Business
Management,​ 2020, doi:10.1007/s10257-020-00466-4.
- Herweg, Müller. “Overconfidence in the Markets for Lemons.” The Scandinavian
Journal of Economics, vol. 118, no. 2, Wiley Subscription Services, Inc, Apr. 2016,
pp. 354–71, doi:10.1111/sjoe.12135.
- Mccaffrey, Matthew. “The Morals of Moral Hazard: a Contracts Approach.” ​Business
Ethics: A European Review​, vol. 26, no. 1, 2016, pp. 47–62., doi:10.1111/beer.12121.