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Chapter 27: Problem 19

Describe what a lemons market is and give two examples.

Short Answer

Expert verified
Answer: A lemons market is a market situation characterized by asymmetric information between buyers and sellers regarding the quality of a product, leading to adverse selection and market failure. Two examples of lemons markets include the used car market, where sellers have more information about a vehicle's condition, and the health insurance market, where insurance providers may have difficulty distinguishing between high-risk and low-risk individuals.

Step by step solution

01

Definition of a Lemons Market

A lemons market is a market situation in which there is asymmetric information between buyers and sellers regarding the quality of a product. The term was introduced by economist George A. Akerlof in his 1970 essay "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism." In a lemons market, sellers have more information about the quality of a product than buyers, leading to adverse selection and market failure. High-quality products are referred to as "cherries," while low-quality products are referred to as "lemons." Due to information asymmetry, buyers are unable to accurately distinguish between lemons and cherries, leading to a decrease in overall market quality.
02

Example 1: Used Car Market

The used car market is a classic example of a lemons market. In this market, sellers have more information about the condition and history of the vehicles they are selling, while buyers often have limited knowledge of the car's true quality. This information asymmetry can lead to adverse selection, where buyers are unsure if a car is a lemon or a cherry and may not be willing to pay a high price for a good quality car. As a result, sellers of high-quality cars may leave the market, further reducing the overall quality of vehicles available for purchase.
03

Example 2: Health Insurance Market

Another example of a lemons market can be found in the health insurance market. Health insurance providers often have limited information about an individual's health status and may have difficulty distinguishing between high-risk and low-risk individuals. In this scenario, high-risk individuals, who are more likely to require expensive medical treatments, may seek out insurance coverage, while low-risk individuals may choose not to purchase coverage. Due to adverse selection, insurance premiums may rise, resulting in a lower overall quality of coverage available to consumers or causing those with lower risks to opt out of the market completely.

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