Question

The Lemons Problem: How Adverse Selection Influences Financial Structure•If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality•Sellers of good quality items will not want to sell at the price for average quality•The buyer will decide not to buy at all because all that is left in the market is poor quality items•This problem explains fact 2 and partially explains fact 1

The Lemons Problem: How Adverse Selection Influences Financial Structure

If a buyer can't determine if a product for sale is a lemon, he will pay only a low value. Sellers of good products won't want to sell at the lower price. The market becomes small and inefficient at moving goods from sellers to buyers. In financial markets, the adverse selection problem suggests that risky firms benefit more from borrowing. If lenders can't distinguish between good and bad firms, they will pay only low prices for securities (that is, charge high interest rates). Good firms won't bother to sell securities at the low price, so the market is small and inefficient. This is a reason why stocks and bonds are not the primary source of financing for businesses.

There are tools to help reduce the asymmetric information problem that caused the lemons problem. These tools help lenders distinguish good firms from bad.

·         Private production and sale of information. Standard and Poor's, Moody's, and Value Line gather information and sell it. However, the free-rider problem (those not paying for the information still benefit from it) reduces the production of private information.

·         Government regulation to increase information. The Securities and Exchange Commission (SEC) requires firms to have independent audits, use standard accounting principles, and disclose information about sales, assets, and earnings. Thus, the financial system is heavily regulated. This reduces the asymmetric information problem, but does not eliminate it.

·         Financial intermediation. Since it is so hard for individuals to acquire enough information to make completely informed loans, most people lend to financial intermediaries, such as a bank, who then lend to the ultimate borrower. The bank becomes an expert in sorting good credit risks from bad. There is no free- rider problem because the bank makes private, non-traded loans rather than buying securities. The larger and more established the firm, the more likely it is that they will issue securities rather than borrow from an intermediary.

·         Collateral and net worth. Collateral is property promised to the lender if the borrower defaults, which reduces the consequences to the lender of a default. Net worth, or equity capital, is the difference between a firm's assets and liabilities. Large net worth lowers the probability of default, and acts as collateral in the event of default.

Question

In Chapter 8 we discuss the lemons problem and its effect on the efficient functioning of a market. Answer the following question.

How might the information about lemons be useful to you, or a friend/ relative in daily life?

Answer 1

Lemons problem arises due to the difference in information available with the buyers and sellers. This is because the seller may not reveal all the information about the product he is selling. He may only share good things about his product and hide any shortcomings. This leads to distrust in the market, and the buyer will be ready to pay only an average rate for the product. In the first instance this looks like a positive outcome. But it is not so because this results in adverse selection; the markets get filled by the sellers of less than average products and the sellers of premium products leave the market.

If my friend or relative will be aware about this lemons problem then in daily life he can benefit by recogniosing this issue. One way of reducing the impact of lemons problem is buying things which comes with warranties of replacement or repair. By doing this my friend or relative will be saved from loss occuring by buying a lemon. Also less sellers of lemon will sell them as the fear of fulfilling the warranty in case of product failure will be there.