"I discovered that the informational problems that exist in the used car market were potentially present to some degree in all markets."
—George A. Akerlof, Nobel Prize winner, 2001

Are you in the market for a vehicle? During the 2007-09 recession, new-vehicle sales plunged to their lowest levels in nearly 30 years. They have since fully recovered as people replace their aging vehicles with shiny new cars, trucks, vans, and sport utility vehicles. Prices of new vehicles, however, are at all-time highs, leading many buyers to look for used vehicles. It can be a challenge, though, for buyers to figure out whether they are getting a good deal. The seller generally knows far more about the vehicle. Even with careful examination, the buyer still likely won't know everything the seller knows. When one party knows more about the product than the other party, there is "asymmetric information." In the case of a used car, the seller has more information—and the advantage. The opposite can also be true in a transaction—the buyer can have more information and the advantage.

SOURCE: FRED^®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=5qkM, August 8, 2015.

The Market for Lemons

The used-car market is often used to discuss the implications of asymmetric information. In this market, sellers have greater knowledge about the condition and quality of their cars than buyers. For example, a seller is likely to know about engine or transmission problems, the maintenance history, and any defective equipment. In other words, the seller is likely to know whether the car is a "lemon" (a car with defects). The buyer, however, is at a disadvantage. Even with a careful visual inspection or a test drive, defects can be missed or hidden. The seller is in the driver's seat (so to speak) in this market.

To better understand asymmetric information, consider a buyer looking for a particular car make and model. Let's call it the 2012 Econocar Utility Maximizer. The buyer is willing to pay up to $14,000 for a high-quality used car (a "cherry") but only $10,000 for a low-quality used car (a lemon). Imagine she visits two sellers advertising 2012 Utility Maximizers. One seller is selling a cherry; the other is selling a lemon. Each seller knows the history of the car for sale—they have good information and know whether it is a cherry or a lemon. The buyer, however, doesn't see much difference between the two cars. She can't tell whether either car is a cherry or a lemon. In other words, there is asymmetric information. As such, because she can't know for sure, the buyer assumes that neither car is of high quality. So, she is willing to only offer a price below that of a high-quality car: $12,000.

Now consider the larger used-car market. Other buyers behave in similar ways. Because they cannot distinguish between lemons and cherries, they offer prices somewhere in the middle. Some sellers who really do have high-quality used cars aren't willing to sell them below their true value, so they keep the cars instead. Sellers of low-quality cars, however, gladly sell their lemons. Low prices, then, reduce the overall quality of used cars on the market, leading to a market dominated by lemons. With fewer cherries on the market, buyers offer even less, further reducing the quantity of high-quality cars on the market. This cycle leads to market inefficiency because transactions that would have benefited both buyers and sellers fail to take place. That is, although sellers are willing to sell high-quality used cars to buyers at a fair price, the transactions do not occur because the buyers are unsure about the condition of the cars.

Closing the Asymmetric Information Gap

Regulation has helped buyers receive better information. The 1975 Magnuson-Moss Warranty Act (also known as the Lemon Law) regulates warranties on vehicles (and other consumer goods), and a variety of state laws (also referred to as lemon laws) protect consumers from defective products, including vehicles.

To reassure used-car buyers—and to get them to pay a higher price—some sellers provide warranties or "certify" their highest-quality used cars. Generally, a car labeled certified has been inspected and repaired (if necessary) to meet high quality standards and may include a warranty. Buyers can also take several steps to help reduce the asymmetric Information gap. First, research can help steer them to a generally more-reliable car. Third-party sources, such as Consumer Reports and J.D. Power, collect and analyze data to estimate the average reliability and quality of certain car models.

Once a seller finds a car, various sources can provide additional information about that car. For example, auto mechanics can look for defects hidden or overlooked. For a fee, they will look "under the hood" and run diagnostic tests. Additional information (such as maintenance, odometer, and accident history) is available by researching the car's VIN (vehicle identification number). Various companies will provide a VIN report for a fee.

In the future, buyers may be able to easily obtain even more information about a car's history from the car's event data recorder (EDR), which is similar to the "black box" on an airplane. Today, nearly all new cars have an EDR. These microcomputers collect data related to safety and accidents, including speed, braking, seatbelt use, and airbag deployment.¹ EDRs are likely to become more powerful and collect more data over time.

Consider the Cost

In the rush to close the asymmetric information gap, it is important to realize that obtaining information can be costly. Some information may have explicit costs (fees or subscriptions), while others have implicit, or opportunity, costs. Any time you spend researching a product is time you could have spent doing something else. There­fore, the more expensive a transaction is, the more beneficial your research may be. So it's wise to seek out information before buying a house or car or choosing a college but less important for choosing a frying pan or a stapler.

Other Markets with Asymmetric Information

Other markets also have the challenge of asymmetric information. In the insurance market, for example, buyers usually have more information than sellers (insurance companies). The person wanting health insurance has more information about his or her current health than the insurance company. This imbalance can lead to two potential problems in the health insurance market. The first is adverse selection: People with health problems are more likely to buy health insurance than healthy people, who might decide they don't need health insurance. This imbalance can create a pool of insured people with more health problems than the general population. If this is the case, health insurance companies will likely pay more claims and charge higher premiums. The Patient Protection and Affordable Care Act has attempted to reduce adverse selection by creating financial incentives to encourage all people (even the young and healthy) to buy insurance.

The second potential pitfall is moral hazard: People with insurance tend to take on more risk (knowing insurance will pay some of the cost if anything bad happens) than they would otherwise. This increase in risky behavior could increase the number of claims insurance companies must pay and result in higher premiums. Insurance companies attempt to learn about a potential customer's health and other habits before granting medical or life insurance to reduce the risk to the company and ensure an appropriate monthly premium is charged.

Credit markets also notably feature asymmetric information problems. A potential borrower has better information about his or her own ability and willingness to repay a loan than the lender. Lenders attempt to learn about potential borrowers' credit and financial history from credit reports. This information improves the ability of lenders to choose whom they should lend to and what interest rate they should charge.

Finally, asymmetric information problems also plague labor markets. Job seekers know more about their own job skills and work ethic than potential employers. Employers generally conduct interviews and check references but may also give assessments and seek additional information online, including on social media. In addition, some employers review credit reports,² require drug testing, and/or perform a criminal background check.

Conclusion

When one party to a transaction has more information than the other, the party with more information has the advantage. This circumstance is a problem not only for the party with less information, but also for the market itself as transactions that would have benefited both buyers and sellers fail to occur. For example, even though some people are willing to sell high-quality cars for a suitable price, buyers won't pay top dollar because they are unable to assess a car's true condition. So, the car owners won't sell, and the beneficial transactions never occur. However, the growing availability of information—if you seek it out—may help close the asymmetric information gap.

Notes

¹ Rafter, Michelle V. "Decoding What's In Your Car's Black Box." Edmunds.com, July 22, 2014; http://www.edmunds.com/car-technology/car-black-box-recorders-capture-crash-data.html.

² Eleven states have banned the use of credit checks in employment decisions (Traub, Amy and McElwee, Sean. "Bad Credit Shouldn't Block Employment: How to Make State Bans On Employment Credit Checks More Effective." Dēmos, February 25, 2016; http://www.demos.org/publication/bad-credit-shouldnt-block-employment-how-make-state-bans-employment-credit-checks-more-e).

© 2016, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.