Imagine that the appearance of all fruit has changed so that they all resemble a gray, fist-sized cube. There's no way to tell what kind of fruit flavor this strange cube is until you take a bite. You could be buying a sweet delicious peach or you might get conned into biting directly into a sour lemon. To make matters worse, the average price of a peach is about five dollars while lemons are worth roughly a dollar. How can you minimize your potential loss in such a market?
It would be really terrible to pay the full price of a peach only to get a lemon, right? So you wouldn’t pay more than the average of the two fruits, which is around three dollars. This way even if you get tricked, your wallet won’t be as sore as your tongue.
This is a smart buyer decision but it falls apart if the fruit sellers know whether they’re selling lemons or peaches. Maybe they found out a way to test the seeds and know what kind of fruit they’ll grow into. A peach seller isn’t going to be able to meet you in the middle - they’ll lose too much money. The lemon seller however is thrilled to make a profit of two dollars. Thus, peach sellers are going to get undercut and the market becomes more appealing to swindling lemon sellers.
Definition of Adverse Selection
This sort of situation involves an economic concept known as adverse selection. Since the buyers and sellers have unequal information, particularly concerning the risk factors of the transaction, one group has a distinct advantage over the other. One side can thus exploit the other for their own gain.
Adverse selection was famously studied in 1970 thanks to George Akerlof and his paper, “The Market for “Lemons”: Quality Uncertainty and the Market Mechanism.” He discussed how shady used car dealers were able to push out more honest salespeople and thus create a market failure.
The average person can’t tell the difference between a quality used car and a defective used car, sometimes called a “lemon.” The seller knows whether the car they have is a lemon or not, but the typical consumer has no idea if the car is good or bad. The buyer and the dealer have different degrees of knowledge on the cars, which is called having asymmetric information. One party has more information than the other.
Shady car dealers can exploit asymmetric information leading to adverse selection. There’s a lot of shady ways to make lemons look attractive and to hide their flaws so they only become noticeable later. Lemon sellers have incentive to lie because they’ll make a bigger profit. The buyer is aware of this incentive to lie and knows that they themselves can’t ensure the quality of the car. Therefore, the potential customer will only pay for the average price.
Since no one is willing to pay the full price of a quality car, the dealers selling them are going to lose business. It’s going to be less appealing for them to remain open and some of them will leave the market. Meanwhile, the market becomes more appealing to lemon sellers since they can still turn a reasonable profit. However, the buyer will eventually realize that it’s become more difficult to get a good used car. In an effort to minimize their loss, buyers will lower the amount of money they’re willing to pay. George Akerlof argued that this would create a feedback loop until the market became overflooded with lemons but no quality cars and no one willing to buy used cars.
A few years after Akerlof’s paper, “The Market for Lemons,” was published, the United States created federal “lemon laws” to help protect buyers across the country. The Magnuson-Moss Warranty Act helps prevent manufacturers from using disclaimers on warranties to mislead consumers.
The lemons problem isn’t exclusive to car dealerships though. It also affects insurance. There’s no way for insurance companies to definitively know if a person is a high risk “lemon” who’s going to cost them a fair amount of money or a low-risk “peach” who’s risk-averse. They thus average the two costs together and have customers pay the average price. The customer, on the other hand, has a good idea of how risk-averse they are. If you don’t take a lot of risks, you’re likely to opt out of the program because it’s too expensive. If you take a lot of risks, you’re going to opt in because it’s comparatively a good deal. In the long run, this means the insurance company is likely to end up with an excess of lemons.
Adverse selection can affect any industry, but only if there’s asymmetric information. If buyers and sellers have the same knowledge of the product and thus the transaction, no party will end up with something they don’t want. This is why there’s a lot of car verification programs and awards - seeing a certificate at a dealership lets you know you’re buying a quality car. If you can find a third party who’s knowledgeable about the industry and goods, you can ensure you’re buying a peach and help the honest vendors thrive while letting the lemons rot.