Definition of 'Lemons Problem'

The issue of information asymmetry between the buyer and seller

of an investment or product. Lemons problem was popularized by
a 1970 research paper by economist George Akerlof. The term is
derived from Akerlof's demonstration of the concept of
asymmetric information through the example of defective used
cars, which are known as lemons in marketplace. In the
investment field, the lemons problem is apparent in areas such as
insurance and corporate finance.
Investopedia explains 'Lemons Problem'
Information asymmetry arises when the parties to a transaction
do not have the same degree of information necessary to make
an informed decision. For example, in the market for used cars,
the buyer generally cannot ascertain the value of a vehicle
accurately and may therefore only be willing to pay an average
price for it, somewhere between a bargain price and a premium
price.
However, this tilts the scales in favor of a lemon seller, since even
an average price for this lemon would be higher than the price it
would command if the buyer knew beforehand that it was indeed
a lemon. This phenomenon also puts the seller of a good used car
at a disadvantage, since the best price such a seller can expect is
an average price, and not the premium price the car should
command.

Adverse selection, anti-selection, or negative selection is a term used

in economics, insurance, risk management, and statistics. It refers to a market process
in which undesired results occur when buyers and sellers have asymmetric
information (access to different information); the "bad" products or services are more
likely to be selected. For example, a bank that sets one price for all of its checking
account customers runs the risk of being adversely selected against by its low-balance,
high-activity (and hence least profitable) customers. Two ways to model adverse
selection are to employsignaling games and screening games.
The term adverse selection was originally used in insurance. It describes a situation
wherein an individual's demand for insurance (the propensity to buy insurance and the
quantity purchased) is positively correlated with the individual's risk of loss (higher risks
buy more insurance), and the insurer is unable to allow for this correlation in the price of
insurance.[1] This may be because of private information known only to the individual
(information asymmetry), or because of regulations or social norms which prevent the
insurer from using certain categories of known information to set prices (for example,
the insurer may be prohibited from using such information as gender, ethnic origin,
genetic test results, or preexisting medical conditions, the last of which amount to a
100% risk of the losses associated with the treatment of that condition). The latter
scenario is sometimes referred to as "regulatory adverse selection". [2]
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MORAL HAZARD
The risk that a party to a transaction has not entered into the
contract in good faith, has provided misleading information about
its assets, liabilities or credit capacity, or has an incentive to take
unusual risks in a desperate attempt to earn a profit before the
contract settles.
Moral Hazard can be present any time two parties come into
agreement with one another . Each party in a contract may have
opportunity to gain from acting contrary to the principles laid out
by the agreement.
Example: When a salesperson is paid a flat salary with no
commissions for his or her sales , there is danger that the

salesperson may not try very hard to sell the business owners
goods because the wage stays the same regardless of how much
or how little the owner benefits from the salespersons work.
Moral hazard can be somewhat reduced by the placing of
responsibilities on both parties of a contract. In the example of
the salesperson, the manager may decide to pay a wage
comprised of both salary and commissions. With such a wage,
the salesperson would have more incentive not only to produce
more profits but also to prevent losses for the company.

Asymmetric Information: Adverse Selection and

Moral Hazard
Asymmetric information, different information between two parties, leads to the following adverse selection, moral hazards, and market failure.
KEY POINTS

Adverse selection is a term used in economics that refers to a process in which undesired results occur
when buyers and sellers have access to different/imperfect information, also known as asymmetric information.

Asymmetric information causes an imbalance of power.

A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by
the party taking the risk.

A lack of equal information causes economic imbalances that result in adverse selection and moral hazards.
All of these economic weaknesses have the potential to lead to market failure.

TERMS

adverse selection
The process by which the price and quantity of goods or services in a given market is altered due to one party
having information that the other party cannot have at reasonable cost.

moral hazard
A situation where there is a tendency to take undue risks because the costs are not borne by the party taking the
risk.
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Asymmetric Information
Asymmetric information means that one party has more or better information than the other when making decisions
and transactions. The imperfect information causes an imbalance of power. For example, when you are trying to
negotiate your salary, you will not know the maximum your employer is willing to pay and your employer will not
know the minimum you will be willing to accept.
Accurate information is essential for sound economic decisions. When a market experiences an imbalance it can lead
to market failure.

Adverse Selection
Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers
and sellers have access to different/imperfect information. The uneven knowledge causes the price and quantity of
goods or services in a market to shift. This results in "bad" products or services being selected. For example, if a bank
set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance
and high activity customers. The individual price would generate a low profit for the bank.

Moral Hazards and Market Failure

In addition to adverse selection, moral hazards are also a result of asymmetric information. A moral hazard is a
situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk . A
moral hazard can occur when the actions of one party may change to the detriment of another after a financial
transaction. In relation to asymmetric information, moral hazard may occur if one party is insulated from risk and
has more information about its actions and intentions than the party paying for the negative consequences of the risk.
For example, moral hazards occur in employment relationships involving employees and management. When
a firm cannot observe all of the actions of employees and managers there is the chance that careless and selfish
decision making will occur.

Moral Hazard
An insured driver getting into a car accident is an example of a moral hazard. The driver will take risks because the cost is not directly felt due
to a transaction. The insurance company pays for the accident and not the driver.

Asymmetric information starts the downward economic spiral for a firm. A lack of equal information causes economic
imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to
lead to market failure. A market failure is any scenario where an individual or firm's pursuit of pure self interest leads
to inefficient results.