Information Economics - The Market for Lemons

The market for used or second hand cars has been a rich area of research for economists interested in information economics.

Nearly 750,000 consumers in Britain face unresolved problems with used car purchases every year. The average age of a vehicle on the road in Britain in 2012 stood at 7.59 years – a 30- year high. Older vehicles tend to have more faults and increase the risks facing a potential buyer.

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• A "lemon" is a dodgy defective (second hand) car
• In the second hand car market, it is very difficult for buyers to discern between a good car (a peach) and a dodgy high-risk car (the lemon)
• Since the buyer of a used car is uncertain of the quality, he will look at the "average quality" in the market – even if the actual quality of this specific item is much higher
• Owners of lemons know more about their car than a potential buyer
• They will tend to sell such a car at the prevailing market price because that price is greater than the car's true value
• Owners of good cars will be reluctant to sell their vehicles at the prevailing average price because it is lower than true value
• When sellers know the quality of individual cars and buyers know only the average quality of all the cars, sellers of good cars may voluntarily remove their vehicles from the market
• This reduces the average quality of used cars available and increases the risk of buying a lemon
• If "bad drives out good" then the used car market might stutter to a complete halt - this is called a "no-trade equilibrium"

The key to overcoming this problem is for purchasers to have better information on the quality of an individual car!

Over-coming the adverse selection problem in the used car market - signalling and screening

1. Warranties and guarantees on used cars e.g. provided by the used-vehicle parts of established car manufacturing businesses
2. Log service records e.g. for second hand cars
3. Rigorous testing of all used cars sold on major showrooms
4. Consumer reviews of second hand car dealerships on the internet - developing a repetitional system
5. Registrar of trusted dealers agreeing to high standards

The aim is to raise the average quality of used cars in the market which in turn will increase price. When market prices are higher, owners of good vehicles are more likely to sell their cars as they will get a proper price for them.

Reading: UK Used Car Commission: http://www.tradingstandards.gov.uk/policy/Usedcarc...

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