The adverse selection is widely cited as an illustration of market failure, calling for government intervention in order to correct the market. The theory is phrased as follows : the buyers of used cars have less information than dealers have about which cars are lemons and which ones are not. The asymmetric information of this kind is likely to destroy the market. Being unable to distinguish between the good and bad product, the potential buyers are reluctant to pay as much money and, because of that, the sellers will withdraw the good cars from the market. Then, the likelihood of getting a bad product increases, and the buyers will drive the price down even more. But the theory neglects the fact that businesses often use guarantees to protect customers from defects. Such warranties provide the information the buyers desperately need before making a purchase of this kind. Such guarantees allow the customers to distinguish between the good and the bad product. The owner of good cars may also sell his car to a garage, and the asymmetric information problem will be resolved. Akerlof simply makes the wrong assumption that buyers are aware of such asymmetric information while for some obscure reasons the sellers are not.
Some Flaws with Akerlof’s Adverse Selection
Some Flaws with Akerlof’s Adverse Selection
Some Flaws with Akerlof’s Adverse Selection
The adverse selection is widely cited as an illustration of market failure, calling for government intervention in order to correct the market. The theory is phrased as follows : the buyers of used cars have less information than dealers have about which cars are lemons and which ones are not. The asymmetric information of this kind is likely to destroy the market. Being unable to distinguish between the good and bad product, the potential buyers are reluctant to pay as much money and, because of that, the sellers will withdraw the good cars from the market. Then, the likelihood of getting a bad product increases, and the buyers will drive the price down even more. But the theory neglects the fact that businesses often use guarantees to protect customers from defects. Such warranties provide the information the buyers desperately need before making a purchase of this kind. Such guarantees allow the customers to distinguish between the good and the bad product. The owner of good cars may also sell his car to a garage, and the asymmetric information problem will be resolved. Akerlof simply makes the wrong assumption that buyers are aware of such asymmetric information while for some obscure reasons the sellers are not.