comes from adverse selection. A typical buyer of used cars considers, “What
kinds of used cars would sellers most likely offer for sale?” The answer is low-
quality cars, including the lemons. The fact that the car is for sale should make
the buyer suspicious.
To see this more concretely, consider someone trying to sell a one-year old
car of a particular model. Suppose that the value of the car ranges from $8,000
to $14,000. (The lemon’s value is $8,000; a prize car is worth $14,000.) Suppose
that all values in this range are considered equally likely. Finally, suppose poten-
tial used-car purchasers are eager to buy. On average, they are willing to pay
$1,000 more for the typical used car than the seller’s value.
If both sides could assess a given car’s true value, buyer and seller could
readily conclude a mutually beneficial sale. A car valued by the seller at, say,
$9,000 would be worth $10,000 to the typical buyer, and both parties would
know this. Thus, the sides could be expected to bargain to a price between
these two values—say, $9,500—and both would benefit from the sale. As long
as bothsides know the car’s value, a mutually beneficial transaction is possible.^3
Suppose now that the potential seller knows the quality of the car but a
potential buyer does not. What can we say about the equilibrium price in this
used-car market? Consider an $11,000 price. If allcars were sold at this price,
sellers as a whole would just break even and buyers would obtain an average
profit of $1,000 (since their average value is $12,000). But adverse selection
dictates that only “lower-quality” cars—that is, only cars that sellers value at less
than $11,000—will be sold. A seller will not sell a car for $11,000 if he or she
knows it to be worth more. In short, only cars with seller values between $8,000
and $11,000 will be offered for sale. With all values in this range equally likely,
the average seller value is $9,500 (the midpoint of this range), and the buyer’s
average value for these cars is 9,500 1,000 $10,500. Rational buyers will not
pay $11,000; this is more than their expected value.
It turns out that $10,000 is the necessary equilibrium. At this price, only
cars with seller values between $8,000 and $10,000 are offered for sale. Thus,
buyers can expect to obtain cars worth (to them) between $9,000 and $11,000,
or $10,000 on average. In equilibrium, lower-value cars dominate the market
and only one-third of the potential supply of cars is sold.
Adverse selection (with asymmetric information as its source) is a general
phenomenon. Banks, credit-card companies, and other lenders face the prob-
lem of distinguishing between low-risk borrowers (those who will repay their
debts) and high-risk borrowers (those who may not). If a bank charges the
same interest rates to both types of borrowers, it will tend to attract the worst
credit risks. This will force interest rates up and further worsen the pool of
credit risks.584 Chapter 14 Asymmetric Information and Organizational Design(^3) If neither side knew the car’s true value, a similar logic would apply. Again, all cars would sell,
regardless of quality. In this case, the average seller’s value is (8,000 14,000)/2 $11,000. In
turn, the average buyer’s value is $12,000. Thus, all used cars would sell for prices between these
two values.
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