1.3 The Market for Lemons

Take a moment and consider what a world with only low-quality, unreliable information would look like. If banks and investors felt that all loan applications and financial statements were unreliable, they wouldn’t lend or invest money to the world’s companies. If companies couldn’t obtain capital through loans or investments, then they wouldn’t be able to open shop, invest in new technologies, expand to new locations, hire new employees, or to invest in new product lines. This lack of growth and investment would result in fewer product innovations for consumers, reduced access to available technologies, and expensive low-quality products caused by inefficient production processes and lower economies of scale. In short, the lack of reliable information would cause any economic system to stagnate and—eventually—collapse.

To illustrate the problem associated with low-quality information available to users of financial statements, consider the market for used cars as described by economist George Akerlof in his 1970 paper entitled: “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Imagine being in the market to purchase a used vehicle. You have no information about the vehicle other than the information provided to you by the seller, and you have no way to verify the information he provides. Because one party in this transaction (i.e., the seller) has superior or greater information than the other party (i.e., the buyer), this arrangement suffers from what is known as information asymmetryinformation asymmetry: A condition when one party to a transaction has more relevant or otherwise superior information than the other party.. As the disadvantaged party in this transaction, your lack of reliable information as to whether the vehicle is a lemon (a defective used vehicle) or a cherry (a reliable used vehicle) leads you to categorize the car as being somewhere in between, or average. If buyers are unable to distinguish between reliable and unreliable information from the seller, then the buyers will treat all vehicles equally and will be unwilling to pay a premium price for any vehicle, even those that are true cherries. However, sellers—who know the true value of the vehicles—will be unwilling to sell their cherry vehicles at the price of an average vehicle. Therefore, the average quality will decline as sellers of cherries remove their vehicles from the market. This process continues, with sellers of above-average vehicles pulling their vehicles from the market and average quality declining until the only vehicles remaining in the market are lemons.

For an example of information asymmetry, watch “The Market for Lemons”: