The Lemons Problem How Adverse Selection Influences Financial Structure

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Lemons in the Stock and Bond Markets

A particular characterization of the adverse selection problem and how it interferes with the efficient functioning of a market was outlined in a famous article by Nobel prize winner George Akerlof. It is referred to as the "lemons problem," because it resembles the problem created by lemons in the used-car market.3 Potential buyers of used cars are frequently unable to assess the quality of the car; that is, they can't tell whether a particular used car is a good car that will run well or a lemon that will continually give them grief. The price that a buyer pays must therefore reflect the average quality of the cars in the market, somewhere between the low value of a lemon and the high value of a good car.

The owner of a used car, by contrast, is more likely to know whether the car is a peach or a lemon. If the car is a lemon, the owner is more than happy to sell it at the price the buyer is willing to pay, which, being somewhere between the value of a lemon and a good car, is greater than the lemons value. However, if the car is a peach, the owner knows that the car is undervalued by the price the buyer is willing to pay, and so the owner may not want to sell it. As a result of this adverse selection, very few good used cars will come to the market. Because the average quality of a used car available in the market will be low and because very few people want to buy a lemon, there will be few sales. The used-car market will then function poorly, if at all.

A similar lemons problem arises in securities markets, that is, the debt (bond) and equity (stock) markets. Suppose that our friend Irving the Investor, a potential buyer of securities such as common stock, can't distinguish between good firms with high expected profits and low risk and bad firms with low expected profits and high risk. In this situation, Irving will be willing to pay only a price that reflects the average quality of firms issuing securities—a price that lies between the value of securities from bad firms and the value of those from good firms. If the owners or managers of a good firm have better information than Irving and know that they are a good firm, they know that their securities are undervalued and will not want to sell them to Irving at the price he is willing to pay. The only firms willing to sell Irving securities will be bad firms (because the price is higher than the securities are worth). Our friend Irving is not stupid; he does not want to hold securities in bad firms, and hence he will decide not to purchase securities in the market. In an outcome similar to that

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