Market for Lemons

Information transmission

An archetypical lemons market existed in India in the 1970s (Klitgaard, 1991).
Quality fresh milk was hard to find, because vendors routinely watered it down. Buyers
could not assess the milk’s butterfat content, and so the low-quality milk drove out the
high-quality milk. Launching a campaign against adulterated milk, the National Dairy
Development Board provided inexpensive machines to measure butterfat content as the
milk moved from farmer to wholesaler to vendor. It also set up payment schemes making
the price of milk reflect its measured quality and created brand names to give buyers trust
in what they were getting. As a result of this coordinated initiative, quality improved and
consumption rose.

The loan market is impeded by information asymmetries: both adverse
selection—a lender may find it hard to distinguish whether any given loan applicant is a
good credit risk—and moral hazard—a borrower, having received a loan, may have an
incentive to default. Since these transaction costs are proportionately larger for small
than for large loans, small lenders often pay exorbitant interest rates or are frozen out of
the loan market. In Bangladesh’s Grameen Bank and other microcredit banks, tiny loans
are made to poor people via groups of borrowers. Each group member is held
responsible for any other member’s loan. Being neighbours, the group members know
each other’s business better than any banker, can monitor each other’s use of the loans
and can invoke social sanctions to discipline defaulters. Group lending is an elegant
solution to the loan market’s informational asymmetries.

The equity market relies heavily on institutions. For shareholders, who lack
information about the firm’s affairs, evaluating managers is difficult, and so a lemons
market may arise. In many countries, lax oversights allow controlling shareholders to
expropriate minority shareholders (Johnson et al., 2000). If the rules governing the
financial markets are inadequate, investors are reluctant to buy stocks because they are
unwilling to trust managers, and so firms do not get the finance they need. A well functioning equity market relies on a complex set of interrelated institutions, formal and informal, to foster information flow (Black, 2001). First, reputations for honest dealings must be built up by auditors, law firms, investment banks and the business press.

Second, there are self-regulating private-sector bodies such as industry associations as
well as the stock exchange, with its rules on listing firms’ financial reporting and its
sanction of delisting. Third, the equity market rests on state-provided mechanisms: not
only laws requiring that investors receive accurate data, but also an activist regulator.
The law’s transaction costs (Glaeser and Shleifer, 2003) mean that a regulator
supplements the courts in setting and enforcing the rules of the game.

Comments

I got this article from http://faculty-gsb.stanford.edu/mcmillan/personal_page/documents/Market%20Institutions.pdf. There is more but i just picked out the section that i think is more interesting so if you wanna read can go there n see :) Basically, this example uses the concept of information asymmetry, which occurs when the seller knows more about a product than the buyer. This concept is found in "The Market for Lemons: Quality Uncertainty and the Market Mechanism", which is a 1970 paper by the economist George Akerlof. It describes how the interaction between quality heterogeneity and asymmetrical information can lead to the disappearance of a market where guarantees are indefinite.

Suxiang