Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

Check your progress:
1. Define Search Cost. 
2. Explain the concepts marginal benefit and marginal cost. 
3. At what point consumer should end the search? 
4. Distinguish between search goods and experience goods. 
 
 
 
 
 
 
 
 
 
 
7.3 ASYMMETRIC INFORMATION: THE MARKET FOR 
LEMONS AND ADVERSE SELECTION 
 
We now discuss asymmetric information and the market for 
lemons as well as the problem of adverse selection in the insurance 
market. 
7.3.1 Asymmetric Information and the Market for Lemons:
Often one party to a transaction (i.e. the seller of the buyer of 
a product or service) has more information than the other party 
regarding the quality of the product or service. This is a case of 
asymmetric information. An example of the problems created by 
asymmetric information is the market for ―lemons‖ (i.e. defective 
products, such as used cars, that will require a great deal of costly 
repairs and are not worth their price), discussed by Ackerlof.
For example, sellers of used cars know exactly the quality of 
the cars that they are selling while prospective buyers do not. As a 
result, the market price for used cars will depend on the quality of 
the average used cars available for sale. As such, the owners of 
―lemons‖ would then tend to receive a higher price than their cars 
are worth, while the owners of high-quality used cars would tend to 
get a lower price than their cars are worth. The owners of high-
quality used cars would therefore withdraw their cars from the 
market, thus lowering the average quality and price of the 
remaining cars available for sale. Sellers of the now above-average 
quality cars withdraw their cars from the market, further reducing 
the quality and price of the remaining used cars offered for sale. 
The process continues until only the lowest-quality cars are sold in 
the market at the appropriate very low price. Thus, the end result is 

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that low-quality cars drive high-quality cars out of the market. This 
is known as adverse selection. 
The problem of adverse selection that arises from 
asymmetric information can be overcome or reduced by the 
acquisition of more information by the party lacking it. For example, 
in the used-car market, a prospective buyer can have the car 
evaluated at an independent automotive service center, or the 
used-car dealer can provide guarantees for the cars they sell. With 
more information on the quality of used cars, buyers would be 
willing to pay a higher price for higher-quality cars, and the problem 
of adverse selection can be reduced. More generally, brand names 
(such as LG Electronics), chain retailers (such as Big Bazaar and 
McDonald‘s) and professional licensing (of doctors, lawyers, 
beauticians, etc) are important methods of ensuring the quality of 
products and services, and thus reduce the degree of asymmetric 
information and the resulting problem of adverse selection. 
Travellers are often willing to pay higher prices for nationally 
advertised products and services than for competitive local 
products, because they do not know the quality of local products 
and services. Thus is why tourists often pay more for products and 
services than residents. Sometimes, higher prices are themselves 
taken as an indication of higher quality.
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