Question

1. Explain why the used car market is both an adverse selection and an asymmetric information problem.

Answer 1

Adverse selection problem arises when sellers have information that buyers do not have or vice versa about certain feature of product or product quality and therefore buyer cannot distinguish between good product or bad product. Whereas asymmetric information arises when one party have more information than other party. In the market of used car, sellers of used cars know the quality of their cars whereas buyers do not have exact knowledge of the car. It can be a possibility that from buyer's point, the car may be a lemon. As a result buyers offer the average quality price of the cars in the market.

On the other hand, when sellers approach the market where average prices are offered, sellers who exactly know (symmetric information) that their cars are of good quality, do not wish to sell their cars at that price in the market. Hence they will withdraw their cars from market and therefore average quality of the cars for sale goes down, since more of bad quality cars are left in the market. Note that when buyer offer average price for used car, seller of bad quality car are getting more price than the worth of their car. And as this goes on only lemons (bad quality car) will remain in the market, resulting in failure of used car market. In conclusion we can say, that information asymmetry, the bad quality product ( used car Or lemons) drives away the good quality ones from the market. This phenomenon is called adverse selection.