Question

Describe the Lemon Problem, advanced by George Akerloff, when there is informational asymmetry between two parties. When there are informational inefficiencies in markets, Myers argues that corporate actions send important signals to market participants. Describe the signals that stock issues and bond issues might send to markets about the firms’ prospects and explain why. Correspondingly, how do markets react to announcements of these two types of security issues?

Answer 1

The Lemon Problem

The lemon problem pertains to the concerns that arise, due to asymmetric information about the value of a product or an investment in the market, between the buyer and the seller. The lemons problem was introduced by George Akerlof, an economist and professor at the University of California, Berkeley, in a 1970 research paper called, "The Market for Lemons". The title of the paper emphasized the problem of information asymmetry with the novel example of buying used cars.

Assume that used cars come in two types: those that are in good repair, and duds (or “lemons” as Akerlof calls them). Now in such a situation if the buyers possessed all the necessary information about the value and trade of used cars then, they can strike fair trades with the sellers. In the sense, good repair sellers get a higher price than the lemon sellers. However, if the buyer does not possess the necessary information about the value and quality difference between a good repair used car and a lemon car, then there will exist only one market for all the used cars, and buyers will be ready to pay only the average price of a good car and a lemon, which is basically somewhere in between the bargain price and the premium price. Now, if this price is less than the price that was anticipated by a good repair seller, then he will exit the market, thereby creating a problem of adverse selection that basically arose from information asymmetry.

The problem of asymmetrical information exists because, buyers and sellers don't usually have the same information that is required to make an informed decision regarding a transaction. The seller usually knows the true value of his offering, or at least knows whether it is above or below average in quality. A potential buyer, however, is not privy to all this information the seller has.

Akerlof in his paper, recommended warranties as one of the means of overcoming the lemon problem. It can effectively protect the buyer from any negative consequences of buying a lemon. The volume and speed of available, widespread information disseminated through the internet today, can also help reduce the problem.

Informational Inefficiencies and Signals sent to market participants

Informational inefficiencies in markets exist when market prices do not quickly and accurately reflect all information and therefore the true value of securities. When this happens, corporates usually undertake certain actions that can act as an indication or signal to the market participants about the business activities and financial capacity of the company.

Thus when a corporate issues stocks, it indicates that the corporate needs capital and is ready to dilute its ownership for the same. If it is a first issue by the corporate it will be seen as a sign of growth and the investors will invest in the stock issues. However if its an additional stock issue, it will be perceived in a bad light by the investors. Since company's main objective is to maximise the stockholder value of its investors, the additional issue would be seen as a dilution of the existing ownership structure, which might make market participants skeptic about the future growth of the company.

Similarly when a corporate issues bonds, it indicates that the corporate needs capital and that there are reasons, like wanting to retain the control of the firm, for which it prefers debt capital over an equity capital. Issuing of bonds also increases the leverage of a corporate which is perceived as an good indicator of a strong credit standing and high borrowing capacity. Thus the market would react to this announcement positively and invest in the debt issuance of the firm.