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The Lemon Market Theory Business Essay

This paper emphasizes the effect of an imbalanced information known as asymmetrical information proposed by George A. Akerlof in 1970 in his seminal paper, “ The Market for Lemons: Quality Uncertainty and the Market Mechanism ” . Information dissymmetry deteriorates the being of market selling good quality merchandises because the imbalanced information rendered to the purchasers during their purchase provokes them to get the ownership of it. Incentives were gettable by the Sellerss to sell these hapless quality merchandises ( “ lemons ” by ( A.Akerlof, Aug 1970 ) ) which were besides the ground that washed off the good quality concerns from the markets. To chalk out out these issues, the Lemon Market Theory ( LMT ) introduced by ( A.Akerlof, Aug 1970 ) is explained here. The paper besides discusses the countries of market criterions that ware affected by the lemon job because the lemon job extremely influenced the chief concern of any market, Trust. We eventually wrap up with the applications where the LMT is used.

Introduction

The Lemon Market Theory ( LMT ) explained by ( A.Akerlof, Aug 1970 ) in his paper describes how markets that sell good merchandises is ne’er identified because of hapless quality providing markets, as Sellerss of the hapless quality merchandises are provided inducements to sell their merchandises. Incentives such as warrants, guarantees and trade name names oppose the quality uncertainness issue. The LMT besides focuses on the information dissymmetry or imbalanced information between the purchaser and marketer, where the full set of Sellerss take the recognition for the quality of the merchandise or service instead than allowing the single quality wages to the appropriate marketer who provides the good quality 1s. This consequence in snuff outing the being of good quality Sellerss from the market because their merchandise ‘s quality or service is ne’er recognized or identified and they are non rewarded either ( Devos, Landeghem, & A ; Deschoolmeester, 2011 ) .

( A.Akerlof, Aug 1970 ) in his theory besides talks about “ Cost of dishonesty ” where the cost includes the dishonesty exercised by the lemon Sellerss to sell their merchandises to purchasers who know certain statistics of the market and see mean market quality. The cost besides includes the demanding force that drives off the guiltless good quality concerns from the market ( Devos, Landeghem, & A ; Deschoolmeester, 2011 ) . He considers the cost of dishonesty to back up the framing of “ Business in developing states is hard ” ( A.Akerlof, Aug 1970 )

( A.Akerlof, Aug 1970 ) Exemplifies the used auto market to explicate the LMT ; bulk of the informations derived to look into the LMT was from the used auto market. “ This theory gained importance in the e-commerce research country with research subjects such as e-markets and auctions ( Dewan & A ; Hsu 2004 ; Lee et Al. 2010 ; Pavlou & A ; Gefen 2004 ) ” ( Devos, Landeghem, & A ; Deschoolmeester, 2011 ) .

Index Footings – Lemon Market Theory, quality uncertainness, information dissymmetry, market quality

LITERATURE REVIEW

Cars Market as an Example:

( A.Akerlof, Aug 1970 ) Used the market for used autos to portray the lemon market job. The job finds its manner by sing four sorts of auto: new auto, used auto, good auto and bad auto ( “ lemons ” ) . The purchaser of a new auto bargains without any anterior cognition of the auto and therefore the auto possibly a lemon or it may non be a lemon. A used auto could besides be a good auto or a lemon ( A.Akerlof, Aug 1970 ) .

To explicate how guiltless purchasers fall into the trap by the bargainer, two chances are used. Probability P denotes the good quality and chance ( 1-p ) denotes the lemon. After a span of clip, the proprietor of the auto assigns a new chance on a bad experience note. An dissymmetry arises because the trading of the purchased lemons with the same monetary value or even an tantamount sum spent during its purchase was impractical. ( A.Akerlof, Aug 1970 )

The lemon job investigates utilizing two types of information: asymmetrical information and symmetrical information. ( A.Akerlof, Aug 1970 ) Assumes that the demands of a used auto depend on the monetary value of the used auto every bit good as its quality and both the supply of the used auto and the quality of the auto depends on its monetary value. Therefore as the monetary value falls, the quality suffers. From the public-service corporation theory, two type of bargainers, bargainer type 1 and bargainer type 2 are considered. By detecting the income of the two types of bargainers, demands for the used autos will be the amount of the demands of both types of bargainers. On a contrast note, the symmetrical information proves that public-service corporation wins the competition and the income of the bargainers are non plenty to purchase cars. With several premises and conditions, quality is merely half times the monetary value of the auto and trades take topographic point when bargainers of one type ( type 2 ) are capable of paying the monetary value offered by type 1 bargainers. ( A.Akerlof, Aug 1970 )

Measurement of the theory:

In the paper SMEs and IT: Evidence for a Market for “ Lemons ” by Jan Devos, Hendrik Van Landeghem and Dirk Deschoolmeester Ghent University, Belgium, Devos et al derives a construction that was used to mensurate and verify and confirm the LMT. The figure below studies out the basic web model. ( Devos, Landeghem, & A ; Deschoolmeester, SMEs and IT: Evidence for a Market for “ Lemons ” , 2012 )

Figure 1: Nomo logical web for LMT

Information Asymmetry: The imbalanced information between two pass oning people of different backgrounds is Information Asymmetry. It is an “ independent concept ” because the accomplishments of either of the two communication people play a drastic function. Within the countries of trading, the purchaser or the marketer via medias on the trade based on the information exchanged between them. The information may be inappropriate or imbalanced pulling lemons into the market. ( Devos, Landeghem, & A ; Deschoolmeester, SMEs and IT: Evidence for a Market for “ Lemons ” , 2012 )

Trust: Trust can be defined as, “ Trust is a dependent concept and can be been seen as a organizing mechanism based on shared moral values and norm back uping corporate co-operation and coaction within unsure environments ” . It is a linking dependent concept between information dissymmetry and repute. Information dissymmetry destroys the trust among bargainers and therefore botching the repute of the trading company. Often trust is the cardinal component between several successful concerns. ( Devos, Landeghem, & A ; Deschoolmeester, SMEs and IT: Evidence for a Market for “ Lemons ” , 2012 ) . Akerlof excessively describes trust in footings of dishonesty in his paper. ( A.Akerlof, Aug 1970 )

Repute: Wilson ( 1985 ) defines repute as “ a characteristic or attribute ascribed to one individual ( or organisation ) by another ( or organisation ) ” . Reputation is the wages to honesty. When a market lacks repute, the bargainers use establishments to sell merchandises of low quality, therefore repute could be a solution to the lemon job ; nevertheless, Yamagishi & A ; Matsuda ( 2002 ) contradicted this. Repute is ne’er a one-person belongings ; a group of bargainers who try to derive success out of it ever inherits it. ( Devos, Landeghem, & A ; Deschoolmeester, SMEs and IT: Evidence for a Market for “ Lemons ” , 2012 )

Adverse choice: The most common mistake all purchasers do is choosing the incorrect marketer. The purchaser has no anterior cognition about the merchandise purchased and therefore swearing the tactics the Sellerss impose, the purchasers fall into their trap. From the marketer ‘s position, inauspicious choice consequences in loss in repute and a outstanding diminution in the quality of the merchandise. ( Devos, Landeghem, & A ; Deschoolmeester, SMEs and IT: Evidence for a Market for “ Lemons ” , 2012 )

Moral jeopardy: Many a times, the marketer does non run into the criterion quality demands of the purchaser. He tries to conceal information about the defect and jobs in the merchandise on sale, which gives rise to moral jeopardies. ( Devos, Landeghem, & A ; Deschoolmeester, SMEs and IT: Evidence for a Market for “ Lemons ” , 2012 )

Validating the theory:

The Lemon Market Theory proposed by ( A.Akerlof, Aug 1970 ) was validated to look into if there truly exits a lemon market in used vehicles ( Hoofer & A ; Pratt, 1987 ) and whether or non, bad merchandises drive out the good 1s in a used choice up truck market. ( Bond )

Chemical bond purposes to differ with the Lemon Market Theory, while Hoffer and Pratt purpose to turn out Bond incorrect.

Eric W.Bond in his paper “ A Direct Trial of ‘Lemons ‘ Model: The Market for Used Pickup trucks ” , argues that there is no appropraite information that proves, lemons empower the used auto markets. Bond choose care, a key to step and measure the quality of a truck with high care vehicles as lemons. These lemons drive out the non-lemons from the markets. It is natural that used vehicles have higher care costs when compared to new vehicles, if it did non so all lemon proprietor would merchandise their vehicles for a new one. However, if the “ age and milage was controlled, there would be no difference in the two classs ” . Reputation eliminates the opportunities of lemon come ining the market, because rendering a bad quality may impact the repute adversely. Information dissymmetry disappears with the fact that purchasers gain the needed information and cognition of the quality of the merchandise therefore there is no opportunities of purchasing a lemon. The market would ensue in trading the good quality vehicles blockading or befoging the entry of lemon. This contradicts with the ( A.Akerlof, Aug 1970 ) ‘s Lemon Market Theory. However, Bond ‘s determination did non last true for a really long clip. Pratt and Hoffer proved him incorrect. ( Bond )

The paper, “ Used Vehicles, Lemon Markets and Used Car Rules: Some empirical grounds ” by George E Hoffer and Micheal D Pratt reviews on whether or non vehicle market was a lemon. Harmonizing to ( Bond ) , the used pickup truck market was a lemon as he proved from his theory that the care costs of the non-traded pick-up trucks and traded pick-up trucks were same. ( Bond ) . ( Hoofer & A ; Pratt, 1987 ) Verified this by utilizing the information and the beginning of the information collected by Bond. They assembled autos prior to one twelvemonth of purchase and autos owned for old ages into separate groups and discovered that the care cost for the autos owned prior to a twelvemonth was higher. Furthermore, merely incentives entirely can non run out out information dissymmetry. ( Hoofer & A ; Pratt, 1987 )

Solution to the Lemon Problem:

Lemon Markets consequences impacts of two sorts, which may be good or bad. A good impact may forestall the growing of a lemon market but a bad impact establishes a steadfast lemon market and therefore the bad quality 1s force the good quality merchandises out. Therefore, fresh bargainers happening their manner into the markets can forestall the farther growing of a lemon market. Innocent purchasers save themselves from falling into trap of the Sellerss by being more aware of their purchase. This would relatively cut down information dissymmetry. Nevertheless, Sellerss can besides lend to the diminution in information dissymmetry by discoursing the mechanical issues and jobs of the used car therefore salvaging an entry of new lemon into the market. ( A.Akerlof, Aug 1970 )

ADDITIONAL THEORIES AND THEIR RELATIONSHIPS

Figure 2: The links of the LMT with Agency Theory, Prospect Theory and Trust Theory ( Devos, Landeghem, & A ; Deschoolmeester, SMEs and IT: Evidence for a Market for “ Lemons ” , 2012 )

Agent Theory:

Agent Theory or Principal Agent theory ( PAT ) investigates the cause for the issues in an “ outsourcing environment ” . It comprises of a Principal ( proprietor ) and an Agent ( seller ) . PAT being the footing for all IS research nevertheless does non lend much towards the research. Goal difference, Risk behaviour difference and Information Asymmetry are the three causes for the issues in the outsourcing environment. The Principal is concealed certain information and the Agent attempts to move harmonizing to his will. This consequences in “ timeserving behaviour ” which farther leads to adverse choice job and moral jeopardies. ( Jan, Landeghem, & A ; Deschoolmeester, 2009 )

Markets for the “ lemons ” theory:

LMT provides a description for lemons in a market. Sellers sell these merchandises obtaining inducements and the repute is been shared by non merely a individual seller, instead the full group. Adverse choice besides consequences due to the being of lemons in the market. ( Jan, Landeghem, & A ; Deschoolmeester, 2009 )

Prospect Theory ( PT ) :

PT defines the phases of decision-making. During the first phase, the redaction phase, a stamp is laid out, which may or may non be of great success. However, it is in the 2nd phase where the success of the stamp plays a critical function within the restraints of hazard. This phase entirely depends on the ways of puting out the stamps. ( Jan, Landeghem, & A ; Deschoolmeester, 2009 )

Trust Theory or Organizational Trust Theory ( OTT ) :

Harmonizing to Devos, Deschoolmeester and Landeghem, “ Trust is important in concern interactions characterized by common dependence combined with a deficiency of common control. ” ( Jan, Landeghem, & A ; Deschoolmeester, 2009 ) “ As stated by Reed, his definition for trust was ‘ [ … ] the indispensable character of all trust dealingss is their mutual nature. Trust tends to arouse trust, misgiving to arouse misgiving… . As trust psychiatrists, distrust takes over. ‘ ” ( Reed, 2001 )

Incomplete Contract Theory ( ICT ) :

A contract is set between the principal and the agent with information dissymmetry as its chief competition. The contract is uncomplete when the agent hides the future effects of the merchandise in trade and when the principal are no anterior cognition about the craft planned for him. However, a complete contract is a crystalline one, which is non practical in a field like trading markets. ( Jan, Landeghem, & A ; Deschoolmeester, 2009 )

Applications

Insurance:

By tie ining the LMT to a medical insurance allowances, people over 65 old ages find it demanding to obtain a medical coverage for themselves. This is because of the monetary value hiking to get one. On the other manus, employees working in companies are offered insurance prior to their work to run into the company ‘s policies and ordinances. Therefore, there is more room for lemons in the insurance field and less opportunities for the aged who require it more. This consequences in inauspicious choice by the insurance companies. ( A.Akerlof, Aug 1970 )

Employment of minorities:

Several companies disagree with the fact that certain places open to the general populace are besides available to people of lower minority groups, here caste and racism plays its function. The background of a individual Judgess his capablenesss and working criterions and therefore the individual engaging an single garbages to engage one from the minority group. The company therefore attracts lemons and minorities with higher working qualities and accomplishments are restricted to chances to turn out their proficient and physical endowments. ( A.Akerlof, Aug 1970 )

Cost of dishonesty:

Cost of dishonesty non merely highlights the cost where the dishonest traders sell merchandises of low quality with guarantees and price reductions but the cost at which the high quality traders disappear from the market. Developing states suffer from this terrible dishonesty job every bit good fluctuations in the quality of the merchandises sold. ( A.Akerlof, Aug 1970 )

Decision

The paper discusses the theoretical account for ‘lemons ‘ market where trust is of chief concern. Information dissymmetry consequences in several losingss to the markets ‘ repute and trust is extremely influenced by the dishonesty among bargainers. Cost of dishonesty describes the important footings of driving good quality gross revenues out of the markets. Adverse choice besides consequences to authorising lemons in the markets, where the purchaser is at mistake.

Several warrants offered stood as the chief ground for production and trades to happen. An uncertainness brushs since, the warrants are non lasting and the markets might endure depreciation at any point. ( A.Akerlof, Aug 1970 ) . The wagess that belong to an single seller for bring forthing a high quality merchandise consequence in sharing among the full group instead than the single himself. The facet of uncertainness includes the trouble in distinguishing the good quality merchandises from the “ lemons ” . ( A.Akerlof, Aug 1970 )

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