Question: Evaluate one possible effect of asymmetric information in the second-hand car market.
Agents have symmetric information when all agents have the same information. Agents have asymmetric information when some agents have more information than others. Asymmetric information can cause market failure.
George Akerlof highlighted that asymmetric information exists in the market for second-hand cars. A second-hand car could be a peach (good quality) or a lemon (bad quality). Assume sellers know if their car is a peach or lemon but buyers do not know. Buyers will only offer an average price for a car whether it is a peach or a lemon. All the peaches will leave the market because peach owners want more than the average price for their good quality car. The market begins to unravel. Asymmetric information causes adverse selection, that is, bad quality cars drive good quality cars out of the market. Only lemons are left, and buyers do not want lemons because they are bad quality cars, so buyers do not demand lemons. A missing market has developed, the market for second-hand cars disappears, there is complete market failure.
However, the government can intervene to correct the market failure. For instance, the government may implement a law stating that all second-hand cars must meet some minimum quality criteria. Also, car sellers could signal that their cars are peaches by offering a warranty.