Question

Lemons Market: A buyer and a seller can potentially trade a car of uncertain quality; the car is equally likely to be a lemon, or a peach. The true value of a lemon is $2,000 and the true value of a peach is $5,000. Buyers buy cars based on their expectation of the true value of cars in the market. Suppose the buyer cannot tell the true quality of the car, but the seller knows the quality of his car. What is the price the buyer is willing to pay at the beginning? Given the price that buyer is willing to pay, what kind of cars will leave the market? In the end, what kind of cars will be traded on the market and what is the trading price?

Answer 1

Answer)

It’s a classic case of asymmetric information and how prices are affected by it. So, if we assume the rational behavior from buyers their behavior to bargain a price will be derived from this limited knowledge about the true nature of car. As they can’t differentiate between lemon and a peach they will due to lack of information to them, they will not pay more than average price which will be $2000 - $5000 (which is somewhere between bargain price and premium price) initially

This has two effects initially seller will reap the benefits of selling’s lemons (which costs them less) at a median price. But also this make Buyers more risk averse to pay premium price of $5000 along the time as the market will have more lemons car’s and certain buyers will not have good experience, which will further promote only sales of lemon can and resulting in bad cars replacing good cars out of market in long term and prices will also go down close to $2000 as buyers will become more and more risk averse because they don’t want to lose a premium amount for a peach type car which they may not get due to less supply of it as it is less profitable for seller

To summarize

1. In beginning buyers will agree to pay somewhere between $2000 - $5000 i.e. the average price.
2. This will result in peach type car to drive away from market.
3. In the end only lemons will be traded in the market at a lower price close to $2000 as the buyers will become more risk averse.