You experience this scenario all the time. You are really excited about a product you bought. But at some point, while you are opening or using the product itself, you start to realize that the product is crap. The quality is nowhere like you expected. You have been deceit by the advertising and the packaging of the product.
The paragraph above is the example and one of the results of the lemons problem. The lemons problem is the problem when low-quality goods drive good-quality goods out of the market. How? First, we need to know that low-quality goods’ price is highly flexible because the cost itself is low. Which means it could easily be adjusted to the price equilibrium (except if the price equilibrium is lower than the cost, which is highly unlikely). When the product’s price is exactly at the equilibrium price, the demand will be optimized. When the product’s price is over the equilibrium price, the customers will look for a substitute product.
If the price of bad products is flexible that makes it adjustable to whatever the equilibrium is, the demand for bad products will be higher than good products. But how it works? Usually, we can differentiate bad and good products right? Well, the lemons problem is usually happening because of asymmetric information. Asymmetric information is the state when one party (in this case, the seller of bad products) have more information than us. Usually, this problem occurs because the sellers claimed that the product’s quality is good, while hiding the real drawbacks, condition, and the quality of the products.
Because most of bad products’ sellers will package their bad products into good products and claim it as good products with low price (because the real cost is low), most of the customers will buy bad products because the price is lower. That makes the sellers of good products can’t compete with their competitor that sells the products with a lower price. That will make the good products demands will plummet down. This makes the sellers of good products will go away from the market. Makes the only products in the market is bad-quality products.
One of the most popular examples of this concept is used car market. According to George Akerlof (the person who discovered this problem), there are 4 kinds of cars. New car and used car, and there also possibilities of good quality car and bad quality car. So you can get bad quality used car, or good quality used car, vice versa.
For example, because I got some money to upgrade my car, I decided to sell my current car that I have been used for 4 years and use the money to buy a new one. So I start digging the market price for my car. Because I am the only owner of the car and I already used it for about 4 years, I know everything about the car. From the malfunctioning air conditioner, to the accident that makes me replace the whole chassis. So after I find the market price for my car which is around $15,000, I decided to advertise my car.
After a couple of weeks, a potential customer calls me and wanted a meeting to discuss the price of the car. So because I want to maximize profit, I decided to sells my car with the price of good-quality used car which is about $15,000. Even though I know that my car is not good quality and not safe to drive anymore because the chassis used is not the chassis that originally made for my car, but I used the cheapest one. This is when asymmetrical information happens. Because I have more information from the buyer, I could hide the information that will reduce the value of my car. So I decided to hide the facts about the replacement of the chassis because it will reduce the value.
Because the person is interested, so he decided to buy my car (because he didn’t know about the replacement of the chassis), so he just assumes that the quality of my car is a good-quality car. But as time goes, as some point he starts to notice that the car he bought is lemons (slang word for bad quality car), is starting to breaks, overheating engine, etc.
What do you think about the lemons problem? Do you ever experience something like this? Tell us in the comment box below!
REFERENCES AND SUPPORTING ARTICLES
Akerlof, G. (1995). The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. Essential Readings in Economics, 175-188. doi:10.1007/978-1-349-24002-9_9
Information asymmetry. (2017, September 08). Retrieved from https://en.wikipedia.org/wiki/Information_asymmetry
The Market for Lemons. (2017, October 04). Retrieved from https://en.wikipedia.org/wiki/The_Market_for_Lemons
Staff, I. (2015, July 29). Lemons Problem. Retrieved from http://www.investopedia.com/terms/l/lemons-problem.asp