ADVERSE SELECTION & THE LEMON PROBLEM

The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence." ~ George Akerlof

Most of the time, sellers have more information about a product for sale than the buyers. Due to which, there is an asymmetry in information between the buyer and seller. George Akerlof, an economist and Nobel laureate demonstrated how this behaviour could alter or shut down markets that would otherwise work well.

'Lemon' was a commonly used slang for defective cars and because the problem was identified in the second-hand car market, it got the name ‘lemon problem’.

In a second-hand car market, there are honest sellers who have well-conditioned cars for sale and dishonest sellers who want to get rid of their defective cars or lemons and it's hard for the buyer to know which car is a lemon and which isn't, due to which arises an asymmetry in information between the buyer and the seller. In such situations, the incentives of both players changes as both start engaging in very strategic behaviour. While the seller wants to make a profit, the buyer wants to avoid losses.

An important insight here is that the potential buyer is aware of the fact that the seller knows more about the product than they do which is why, to cut their losses the buyer ends up averaging the cost.

Suppose, the good cars are sold at $4000 and the lemons are sold at $2000. A buyer who can't differentiate between a good car and a lemon assumes that there is a 50-50 chance of getting either one of them. They agree on paying an average amount of $3000 for the used car (lemon or not). Doing so will encourage the lemon sellers as they make a profit by selling garbage at a higher cost than its true value. And over time all the good cars will be driven out of the market. The market might eventually collapse because of this ongoing adverse selection process.

The same concept works with health insurance companies. Insurance companies provide insurance to a wide range of people. On one extreme there are the people that often get sick or participate in dangerous jobs and on the other end there are fit and healthy people. In this situation, the buyers know more about their health status than the insurer (seller). But according to this theory, the insurer should average the cost among all consumers just like the buyers did in the second-hand car market and charge the same premium to all. This will result in a portion of healthy people preferring not to buy health insurance as the cost of the insurance will be greater to them than the expected benefits. If this is valid, then why does everyone have health insurance at all?

Although the hypothesis is valid, reality differs greatly from theory where we assumed that the decisions made were only based on price. There exist various market mechanisms to ameliorate the problem. Some of these mechanisms being:

• Warranties that assure the buyer of the quality of the product. In case the buyer purchases a faulty product, he can opt to either return it or replace it.

• A company requires an authorized license by the government to trade, thereby decelerating the entry of lemons into the market.

• Some countries have adopted laws similar to lemon laws (American state laws) according to which if a car meets the lemon law requirements the consumer should be entitled to obtain a refund or replacement car from the manufacturer.

• Another efficient way is to equip yourselves to fight against the problem by hiring an expert or by taking advantage of inspection services while buying a ‘second-hand car’, thereby eliminating the lemon problem.

Insurance companies have an effective underwriting process where they collect all the vital information about their customers. They avoid the adverse selection problem by increasing premiums for the high-risk policyholders and in contrast, consumers under less risk will be paying less.