Lemon car.
The term may seem absurd, but it doesn’t actually refer to a car made of the sour fruit we use to make delicious pies. In the world of automobiles, this term carries an entirely different meaning. Lemons are actually vehicles that have several issues and defects, which affects its safety, value and utility.
The market for such cars arises due to the simple market situation of adverse selection. Adverse selection occurs when one party in an economic transaction has access to better information about the quality of a product than another party. This gives rise to a market whereby a seller of a product who knows more about the quality of a product will selectively enter a market which benefits them the most, at the expense of the buyers who do not know about the quality of a product due to the imperfect flow of information in a market.
For example, in an ideal market for second hand cars, consumers would be able to differentiate between low quality cars - lemons, and high quality cars - peaches. Consumers may choose different types of cars based on their ability to spend on these cars. However, in the real world, information asymmetry exists. It is impossible for the consumer to determine the exact quality of a used car until after purchasing it. Thus, the seller of the used car has more information than the prospective consumer. The danger here is that the seller does not act in the consumer’s best interest. The seller may, for example, carelessly “forget” to tell prospective consumers about certain issues with the car’s engine, or the car’s history. This gives rise to a murky market, where prospective consumers of the used cars are constantly suspicious of the car’s quality.
To guard themselves against the purchase of lemon cars, consumers may tend to demand fewer used cars and thus lower the price of used cars. As a result, high quality used cars may be driven out of the market. This results in market failure as resources are overallocated towards low quality cars being available in the market since there is no real distinction in price between lemons and peaches. Depending on the difference in the information consumers and sellers have, the larger or smaller this issue may be. Finally, this gives rise to adverse selection, whereby there are too many lemons, and insufficient peaches in the used car market.
In real life however, the used car market is thriving. Nearly 3 times as many used cars are sold than new cars. This is because appropriate solutions have been drawn up to combat this issue. Governments have tried to improve the flow of information such that consumers have enough information to make an intelligent choice, and have set regulations that prevent sellers from taking advantage of consumers by requiring them to provide certain pieces of information. For example, Singapore has set up lemon laws, which includes a 2-stage recourse framework. Consumers can either ask sellers to repair or replace the faulty goods, or request for a refund or reduction in price. In the US, most state lemon laws specify that a manufacturer must provide a refund or replacement for a defective new vehicle when a substantial defect cannot be fixed in four attempts, a safety defect within two attempts or if the vehicle is out of service for 30 days within the first 12,000 to 18,000 miles or 12 to 24 months.
The issue of adverse selection extends far beyond the used car market, such as in the healthcare insurance market. Consumers will have more information about their own lives than insurance providers, and thus may be unlikely to reveal the full extent of their healthcare issues in order to pay a smaller premium. As a result, a similar average premium is charged to both high risk and low risk consumers. The premium charged will represent food value for high risk consumers, as it is likely to be lower than their average medical cost, while the opposite holds true for low risk consumers, who may then decide to drop out of the market - causing adverse selection.
In the market, the concept of adverse selection isn’t just theoretical, it is a fundamental consideration that can make and break financial transactions. Understanding the implications of hidden information, whether you’re buying a used car or purchasing insurance, is essential to be an informed consumer. So, if your parents ever hand you the keys to an old family car, be sure to ask them whether it is a lemon!
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