If information is not the same for buyers and sellers, markets may be dominated by low-quality products. This type of market failure is due to asymmetric information. It is called the lemons problem because cars (particularly used cars) that turn out to be bad deals are called lemons. The potential buyer of a used car has relatively little information about the true quality of the car. The only way the buyer can find out is to purchase the car and use it for a time. In contrast, the seller knows a lot about the true quality of the car because the seller has been using the car for some time. The owner of the used car knows whether or not it is a lemon. In situations like this, with asymmetric information between the buyer and seller, buyers want to pay only a price that reflects the lower quality of the typical used car in the market, not a price that reflects the higher value of a truly good used car.

From the car seller’s point of view, given that the price of used cars will tend to reflect average qualities, all of the owners of lemons will want to put their cars up for sale. The owners of high-quality used cars will be reluctant to do so. The logical result of this adverse selection is a disproportionate number of lemons on the used car market and consequently relatively fewer sales than would exist if information were symmetric. The result is that lemons will be overpriced and high-quality used cars will be underpriced.

Can government policy improve this market?