Lemons Problem

Lemons: they’re great when they’re in our iced tea, but not so great when they’re...our car.

We just don’t understand it: we bought the same year, make, and model car as our twin sister, at the same dealership, for the same price, just one day after she bought hers. Which is...totally not weird at all. Anyway, her car is an absolute peach. It runs like a dream, it looks great, and it doesn’t make that weird wump-wump-wump sound that ours does every time we get over 40 mph.

How did this happen? How did we end up paying the same price as our twin for such a craptastic car?

Well, according to economist George Akerlof, what we have here is a case of the lemons problem. The “lemons problem” is what happens when buyers and sellers come into a situation with different, or asymmetrical, information about the asset in question. We don’t know whether the car we’re about to buy is a lemon or a peach, so we offer a price that’s fair for something in-between the two, just in case it’s a little more on the lemony side. In our sister’s case, this strategy worked out well. She got her money’s worth. But in our case, the dealer walked away a winner, since there’s a real good chance they knew the car was a lemon and sold it to us anyway.

Dr. Akerlof came up with the lemons problem back in 1970 and eventually won a Nobel Peach Prize for his research regarding asymmetric information. We used the example of the used car because, well, it’s a good example, but this issue occurs whenever buyers and sellers have asymmetrical information about an asset. It’s always the seller (or borrower, in the case of a loan) who has more information, and it’s always the buyer (or lender) who has to decide whether they’re about to bite into a peach…or a lemon.