# The Problem of Lemons: Buyer vs. Seller

![Lemon Problem: An information asymmetry between the buyer and seller of an investment or product.](https://www.investopedia.com/thmb/yefWYMFTCh4W256BiZSgHiMwulk=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/lemons-problem.asp-FINAL-2-f1553e5e85dd473da34370ef3753a86c.png)

*— Investopedia / Joules Garcia*

> **Definition**
>
> The lemon problem occurs when buyers have less information than sellers about a product's quality. This leads to a decline in the overall quality of goods and market failure.

## What Is a Lemon?

The theory of lemons was put forward in a 1970 research paper in _The Quarterly Journal of Economics_, titled "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," written by George A. Akerlof, an economist and professor at the University of California, Berkeley. A lemon problem arises regarding the value of an investment or product due to asymmetric information possessed by the buyer and the seller.

### Key Takeaways

*   The lemon problem refers to the issues regarding the value of an investment or product due to a different set of information known by the buyer and the seller.
*   The theory was described by George A. Akerlof, an economist, who presented his ideas in a research paper titled "The Market for "Lemons": Quality Uncertainty and the Market Mechanism."
*   "Lemon" is a slang term for a vehicle with many problems and defects that negatively impact its utility and worth.

## Understanding Asymmetry of Information

Nobel Prize recipient George Akerlof examined the used car market and illustrated how the [asymmetry of information](https://www.investopedia.com/terms/a/asymmetricinformation.asp) between the seller and buyer could cause the market to collapse, getting rid of any opportunity for profitable exchange and leaving behind only "lemons," or poor products with low durability that the buyer purchased without sufficient information.

Asymmetrical information means that buyers and sellers don't possess equal information required to make an informed decision regarding a transaction. The seller or holder of a product or service usually knows its value or at least knows whether it is above or below average in quality. Potential buyers, however, typically lack this knowledge and can only rely on the seller's information.

## The Lemon Problem in the Automobile Industry

Akerlof's example of the purchase of a used car noted that the potential buyer of a used car cannot ascertain the value of the vehicle. Therefore, they may be willing to pay no more than an [average price](https://www.investopedia.com/terms/a/averageprice.asp), which they perceive as between a bargain price and a premium price.

Adopting such a stance may offer the buyer financial protection from the risk of buying a lemon. Akerlof pointed out, however, that this stance favors the seller since receiving an average price for a lemon would still be more than the seller could get if the buyer knew that the car was a lemon.

Ironically, the lemons problem creates a disadvantage for the seller of a premium vehicle since the potential buyer's asymmetric information—and the resulting fear of getting stuck with a lemon—means they are unwilling to offer a premium price for a vehicle of superior value.

> **Fast Fact**
>
> The U.S. “lemon law” that sets regulations for consumer products covered by written warranties is found in Title 15, Chapter 50 of the U.S. Code, in Sections 2301-2312, also known as the Magnuson Moss Warranty Federal Trade Commission Improvements Act.

## The Lemon Problem in the Financial Industry

The lemon problem is not limited to consumer goods like used cars—it also plays a role in financial markets. One example is the [initial public offering](https://www.investopedia.com/terms/p/publicoffering.asp) market, where company insiders typically possess far more information than retail investors. Insiders understand the firm’s true financial health, growth prospects, and potential risks, while the public relies largely on prospectuses and media coverage. This discrepancy can lead to overvaluation where investors pay too much for a company whose internal risks or prospects are weaker than advertised—essentially purchasing a financial "lemon."

In the credit market, similar issues arise. Borrowers inherently know more about their own financial stability and intentions than lenders do. This creates a classic case of adverse selection: those most eager to borrow may also be the riskiest. If lenders can't reliably assess a borrower's [creditworthiness](https://www.investopedia.com/terms/c/credit-worthiness.asp), they may raise interest rates for everyone to hedge their risk. This, in turn, drives away low-risk borrowers who don’t want to pay more than they should, leaving behind a pool of higher-risk borrowers and increasing default rates.

Mergers and acquisitions represent another arena where the lemon problem can surface. Sellers of a company usually know far more about the firm’s internal liabilities, cultural challenges, and operational flaws than the potential buyer. In some cases, buyers discover post-transaction that they’ve acquired a business plagued by problems, resulting in costly write-downs or failed integrations. For instance, the merger between AOL and Time Warner, valued at $165 billion, resulted in a $99 billion write-down.

## Protection From Lemons

The lemon problem exists in the marketplace for consumer and business products and investing, related to the disparity in the perceived value of investments between buyers and sellers.

Akerlof proposed strong [warranties](https://www.investopedia.com/terms/w/warranty.asp) to thwart the lemons problem, as they can protect a buyer from any consequences of buying a lemon. Another solution Akerlof did not know when he wrote the paper in 1970 is the explosion of readily available information disseminated through the Internet. Information services such as Carfax help buyers feel more confident by providing a vehicle's history.

## Potential Economic Implications of Lemons

The lemon problem, at its core, introduces economic inefficiencies by distorting the pricing mechanisms in a market. When buyers cannot distinguish between high- and low-quality products, they are only willing to pay a price that reflects the average expected quality. As a result, the [price ceiling](https://www.investopedia.com/terms/p/price-ceiling.asp) created by this uncertainty fails to reward sellers of high-quality goods, discouraging investment in quality.

One major consequence of this phenomenon is [adverse selection](https://www.investopedia.com/terms/a/adverseselection.asp), where the market selectively retains lower-quality goods. Since sellers of high-quality goods cannot command appropriate prices, they are incentivized to exit the market, leaving behind only the sellers of “lemons.” Adverse selection is particularly problematic in markets where quality cannot be directly observed or easily verified (like used cars).

The erosion of trust also contributes to reduced transaction volume. In markets plagued by lemon problems, buyers may choose not to participate at all, fearing poor outcomes. This hesitancy diminishes liquidity. For example, in [peer-to-peer](https://www.investopedia.com/terms/p/peertopeer-p2p-service.asp) marketplaces or informal economies, a single bad transaction can tarnish the reputation of the entire platform. This is why some buyers may only agree to purchase a car through a dealership as opposed to more informal methods like Craigslist.

Over time, this breakdown in market efficiency can resemble a market failure, where private transactions do not lead to socially optimal outcomes. Instead of facilitating value creation and exchange, the market collapses under uncertainty and distrust.

## What Is the Lemons Theory?

The basic tenet of the lemons principle is that low-value cars force high-value cars out of the market because of the asymmetrical information available to the buyer and seller of a used car. This is primarily because a seller does not know the value of a used car and, therefore, is unwilling to pay a premium on the chance that it might be a lemon. Premium-car sellers are not willing to sell below the premium price, so only lemons are sold.

## What Percentage of New Cars Are Lemons?

It is estimated that each year, approximately 150,000 cars (1%) are considered lemons; however, it is believed that the number is probably higher due to people not reporting defective cars or not being aware of the extent of the defects.

## What Are Lemon Laws?

Lemon laws help provide a solution and protection for purchasers of cars and other goods. They implement compensation programs for buyers when the products fail to meet quality and performance standards.

## The Bottom Line

"Lemon" commonly refers to a vehicle with defects that negatively impact its worth. The lemon theory was described by Nobel Prize recipient, George A. Akerlof, an economist, who noted the asymmetric information available to the buyer and seller when purchases are made in the marketplace.

> **Article Sources**
>
> 1.  The Nobel Prize. "Writing the “[The Market for ‘Lemons'”: A Personal Interpretive Essay](https://www.nobelprize.org/prizes/economic-sciences/2001/akerlof/article/)."
>     
> 2.  Federal Trade Commission. "[Magnuson Moss Warranty-Federal Trade Commission Improvements Act](https://www.ftc.gov/legal-library/browse/statutes/magnuson-moss-warranty-federal-trade-commission-improvements-act)."
>     
> 3.  Fortune. "[15 Years Later, Lessons From the Failed AOL-Time Warner Merger.](https://fortune.com/2015/01/10/15-years-later-lessons-from-the-failed-aol-time-warner-merger/)"
>     
> 4.  CARFAX. "[What To Do If You Were Sold A Lemon Car](https://www.carfax.com/blog/you-bought-a-lemon)."
>     
> 5.  NOLO. "[Lemon Law for New Cars](https://www.nolo.com/legal-encyclopedia/lemon-law-used-cars-30107.html)."