Question

Use the following information to work. Larry has a good car that he wants to sell; Harry has a lemon that he wants to sell. Each knows what type of car he is selling. You are looking at used cars and plan to buy one. If you made an offer of the same price to Larry and Harry, who would sell to you and why? Describe the adverse selection problem that arises if you offer the same price to Larry and Harry.

Short answer

Harry will sell because his lemon is overvalued at the offered price. This leads to adverse selection, as the buyer is more likely to end up with a low-quality car.

Step-by-step solution

Identify the Sellers and Their Cars

There are two sellers: Larry, who is selling a good car, and Harry, who is selling a lemon. Importantly, each seller knows the type of car they are selling, but you do not.

Understand the Offer

You plan to make an offer at the same price to both Larry and Harry. This means that the price you are willing to pay will not change depending on the quality of the car.

Evaluate Who Will Sell to You

Given that you offer the same price to both sellers, Harry, who is selling the lemon, is more likely to accept your offer because the lemon is worth less than a good car. Larry, who knows the value of his good car, would likely decline the offer if it does not meet the value of his good car.

Describe the Adverse Selection Problem

Adverse selection occurs when one party in a transaction has more information than the other. In this case, you, the buyer, are at a disadvantage because you do not know the true quality of the car. By offering the same price to both sellers, you are more likely to be sold the lemon (Harry's car) because Harry is more inclined to accept an offer that overvalues his low-quality car.

Key concepts

Information Asymmetry

Information asymmetry occurs when one party in a transaction has more or better information than the other party. In the example with Larry and Harry, you, as the buyer, cannot differentiate between the good car and the lemon.
This lack of information puts you at a disadvantage.

• Sellers know the quality of their cars, but buyers do not.
• This imbalance affects your decision-making process.

With information asymmetry, you're unable to accurately assess the true value of the car you are buying, leading to potential poor decision outcomes.

Market for Lemons

The 'Market for Lemons' is a term coined by economist George Akerlof in his famous 1970 paper. It describes a situation where quality in goods cannot be properly assessed by buyers.
Here’s how it applies to our scenario:

• Good cars and lemons are sold at the same price.
• Sellers of lemons (Harry) are more likely to accept the offer, since it overvalues their product.
• Sellers of good cars (Larry) will avoid the offer if it undervalues their car.

Consequently, the market becomes dominated by lemons because high-quality products are driven out, resulting in a 'market for lemons.'

Buyer-Seller Dynamics

Buyer-seller dynamics are crucial when understanding adverse selection. Here’s why:
Both buyers and sellers react to the information they possess.

• Sellers (Larry and Harry) act based on their knowledge of the car's quality.
• Buyers make offers based on the average value they perceive, not knowing which car is the lemon.

Because of this, sellers of higher-quality goods (Larry) are less motivated to sell at the offered price.
This dynamic affects the decisions both parties make, often leading to a situation where only lower-quality goods (Harry's lemon) remain in the market.

Decision Making under Uncertainty

Decision making under uncertainty is challenging, especially in markets with information asymmetry. Here's what you need to know:
You, as the buyer, must decide without knowing all the facts.

• If you offer a price assuming the average car quality, you risk overpaying for lemons.
• If you offer a lower price, you might miss out on good cars.

This uncertainty forces buyers to be cautious, often leading them to undervalue the cars.
This cautious approach might protect buyers financially, but also results in the good cars being less frequently bought and sold.