Information asymmetry is an important topic in any market. It presents itself in situations where the selling party knows something important about the product, which the buyer does not know. In the case of second-hand car dealerships, this phenomenon, known as the principal-agent problem, arises when dealers offer cars of lower quality (lemons) at similar prices to cars of higher quality (peaches) (Kim, 1985). This makes it much harder for buyers to distinguish between good and bad quality cars. In practice, this pricing method allows dealers to sell low quality cars to naïve buyers for the same price as higher quality cars. Dealers benefit from these transactions, as they sells cars for higher prices than their true value.
However, buyers suffer from the consequences of their buy. They regarded the car as functional and believed it fit their requirements at the point of sale. Unfortunately for the buyer, the car they bought will likely have problems which went unnoticed at sale but become apparent after some driving time. When buyers in the market find out that some cars are lemons, but they cannot distinguish them from peaches, they will stop buying cars until they can distinguish between them. Nevertheless, instead of distinguishing between lemons and peaches through prices, it is more beneficial for the dealers if they do not distinguish (if they do distinguish, selling lemons becomes really hard). Since nobody wants to buy the dealers’ cars anymore dealers keep lowering the prices, still not distinguishing between lemons and peaches. Eventually, the prices become so low that the dealers cannot come around from the revenue from car sales and the market will collapse.
This market for lemons has to be controlled in some way to prevent dealers to be able to benefit from selling low quality cars at too high prices and causing the market to collapse. One way to solve the problem is to implement a market-wide, government-ordered warranty for each sold car. This will force dealers to distinguish between lemons and peaches, because they would have to pay for the repair costs of the bad quality cars they sold, if they were to break, so they give lemons either a shorter warranty, or a lower repair limit. This solution has two possible, likely positive consequences for buyers in the market. Either dealers will distinguish between lemons and peaches, allowing buyers to choose a car that fits their requirements fairly and more easily. Or dealers will stop selling lemons and only sell peaches which means buyers will only be offered good quality cars. Either way the market survives and does not collapse on itself.
Kim, J.-C. (1985). The Market for “Lemons” Reconsidered: A Model of the Used Car Market with Asymmetric Information. The American Economic Review, 75(4), 836–843. http://www.jstor.org/stable/1821360
