Problems of Asymmetric Information

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Problems of Asymmetric Information
Asymmetric information problems are eminent in nearly every market. Each market is unique and different issues emerge depending on the market type. The real-world problem of asymmetric information is the lemon problem. It describes a market failure caused by imbalanced communication between a buyer and a seller. George Arkelof, an American economist, famously described this problem in his research paper, ‘‘The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism’’. He stated that unequal information between buyers and sellers makes one party take advantage of the other (Akerlof 488). That party can exploit the inequality for their gain while purposefully harming the other, a situation known as adverse selection. In adverse selection, products of different qualities are sold at equal prices because buyers and sellers have unequal information about them (Ikeda 95).
If the buyers cannot tell the quality of a product or service and are willing to pay an average price, this price becomes more attractive to the sellers with low-quality products or services than those with high-quality products (Akerlof 489). As a result, more bad products (lemons), will be available in the market than good products. Rational consumers should anticipate this problem and expect that a randomly chosen product or service has a higher chance of being a lemon than a quality product at any given cost. These expectations mean a lower willingness to pay, resulting in a further fall in the proportion of good products offered. This process may force the market to break down completely.
The Informational Asymmetry
When two transacting business parties can access similar relevant information, their business relationship is symmetrical. However, in many transactions, one party has access to more or better details than the other –a condition known as information asymmetry (Benner and Zenger 71). Access to more relevant and updated information by one party can result in business imbalance exploitation. When it ensues, it always affects one group with little information. For example, an insurance company may incur losses if the insured lacks honesty. If the insured do not reveal that they are heavy smokers and frequently engage in risky recreational activities, this asymmetrical information flow could increase insurance premiums for all customers, forcing the healthy to withdraw. In the same context, insurers believe that at-risk individuals are more willing to pay higher premiums. Suppose the company charges an average cost, but only high-risk consumers purchase the premiums; the firm takes a financial loss by paying out more claims (Akerlof 493).
How the problem has been studied in Two Research Papers
The lemons problem has been studied in Arkelof’s research paper, ‘‘The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.’’ This paper studied the lemon problem using the example of used cars. The author examined the second-hand car market and considered a situation where the sellers are more informed than the buyers. Arkelof noted that this differential information could drive used cars out of the market (488). It is because the information possessed by the dealers destroys the market and opportunities for profitable exchange. The research found that in markets with unequal information flow where product quality is unobservable to customers before purchase and use, introducing a low-quality product causes the market's collapse for higher-quality counterpart (s).
According to this study, the effect of uninformed buyers and informed sellers causes the lemon problem. At any given price, lemons and only a few good cars are in the market, and the buyers are not aware of their quality; they are not willing to pay as much as the actual value of high-quality cars offered for sale. This situation causes the market to collapse. Suppose lemon owners are willing to sell for $1200 and plum owners are willing to sell for $2200. On the other hand, buyers are willing to purchase a lemon for $ 1400 and a plum for $2600. Assuming that only the sellers know the details of the product and all customers know that half of the second-hand cars are lemons. Based on the buyers’ assumption and the expected possibility that a particular car is a lemon, they are willing to pay only $2000 for any car. However, plum dealers are not willing to sell for that price. Therefore, only lemon owners will sell.
The logic is that inferior goods damage the market for quality products when the information is imperfect. The source of this market failure is an externality between the sellers of quality and non-quality products. Any attempt to sell a high-value product affects the consumer’s view of the quality of the average product offered. It reduces the price buyers are willing to pay for the average product, discouraging dealers of high-quality products (Akerlof 494). As a result, the products people want to dispose of are most likely to be available in the market for sale. To solve this problem, buyers should become informed or hire professionals to inspe...