Rotten Lemons Problem

The term "lemons problem" was coined by Nobel laureate George Akerlof in 1970. Roughly, it refers to markets in which there is asymmetric information, meaning that sellers know more than buyers about product quality. Akerlof studies the used car market and finds that it is often impossible for buyers to distinguish bad cars from the good ones. As a result, both good and bad cars are given the same price, thus reflecting a huge discount for the former to compensate buyers in the event of seemingly good cars turning out to be bad.

A commonly suggested solution to the problem is that sellers should find a mechanism, e.g. advertising, to let buyers distinguish accurately between the two types of cars, eliminating the asymmetric information. If this cannot be done, for example when bad car dealers cheat and buyers cannot verify, one might then encounter an even older (and sadder) problem in economics: "bad money drives out the good (also known as Gresham's Law)," which was originated in as early as the 16th century.

When good money (in terms of appearance and real value of the materials used, etc) and bad money are forced to have the same monetary value because they are legal tenders, people tend to save the good and spend the bad. (Imagine in a situation where you have to spend either an ugly torn one-dollar bill or a beautiful antique one-dollar coin, both of which can buy you a dollar's worth of goods.) After a while, all the money circulating in the market will be bad money, since good money is held in people's hands. In the context of the used car market (or any other market in which there is asymmetric information between buyers and sellers), all good used cars will disappear in the long run. Sellers will utilize their cars until they are bad, since good cars do not generate a higher revenue.

Sometimes the problem is worsened when the bad actually fares better than the good. In the pathetic situation when "best guys finish last" or "good girls love bad guys," it makes no sense to be good guys, since they are driven out by the bad even more quickly. I shall call this the "rotten lemons problem," which is, both literally and conceptually, much worse than the original lemons problem.