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Lemon Laws Market Efficiency

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Incomplete information frequently lowers the average quality of products and services exchanged in markets. This phenomenon, at times called the "lemons problem," explains why the supply of lower-quality products increases relative to higher quality products when sellers cannot communicate the quality of their products to potential buyers. Discuss:
a. Why efficiency in markets with incomplete information present lower than in those with perfect information.
b. How "lemon laws" that allow buyers to return used cars or other products that turn out to be "lemons" help to correct the problem.
c. How certifications and warranties can reduce inefficiencies.

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Solution Summary

This posting gives you a step-by-step explanation of how market efficiency is improved through lemon laws. The response also contains the sources used.

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Step 1
Efficiency in markets with incomplete information is lower than in those with perfect information. The efficiency is lower because the buyer has lower information about the product than the manufacturer. The efficiency is low because he seller apprehends he may be misled, the buyer is unaware of the true quality of the product, and often the buyer does not know even the health risk of the product. Low efficiency leads to a situation where supply of lower quality goods increases because lower quality goods have lower costs for ...

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