Lemon Problems And Its Effect On Stock Market

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Lemon problems, also known as adverse selection problems, negatively impacts both exchange market and residential property, but not equally. In fact, its effect on stock market is more than residential property, due to the higher level of asymmetric information influence on market than property as will be discussed below.

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The existence of asymmetrical information forms a lemon problem. If investors are not able to tell the quality of shares and desire to pay just an average value for it, this value will become increasingly attractive to sellers who hold bad shares than to sellers who own good shares. Consequently, there will be more bad securities like lemons being offered. If investors are more rational, they shall anticipate this lemon problem and expect that a randomly chosen share is more likely to be bad (i.e., lemon). In turn, less willingness to buy a share will be implied along with these expectations and as a result the number of good shares which is actually offered will be falling further. Eventually, this procedure may lead the exchange market to a complete and deep break down. In fact, investors will be more pessimistic, in an extreme version of the Lemon problem and as a result, they will lose their trust and willingness to buy a share, thus no trade will take place. A study by Bener and Zenger (2015) emphasizes this finding by indicating that, in the long term the lemon problem may cause a recession since premiums are being held by good sellers and only lemons are trading by bad sellers. When investors find out they have lost a big amount of their money on lemons, they will lose their trust and willingness to invest in stock market which leads to recession.

Adverse selection problems arise in exchange markets when obtaining information relating to the share quality is difficult and costly. Entities willingness to provide accurate and enough disclosures, is another reason of existence of lemon problem too. In this case, one of the appropriate solutions is that managers provide suitable strategies such as disclosure of accurate and analyzed information with a good quality to decrease the asymmetry in the market. Accordingly, strength of the disclosure system is positively associated with market development. Our findings are consistent with the view that stock exchanges may beneficial in several ways from promoting timely and credible disclosure of company information. Overall market development may increase, as reflected in larger more active markets in which investors are more willing to participate. Capital formation may also strengthen, and economic growth may result.

Lemons problem influence on residential property too due to the information asymmetry and level of disclosure, but It is less than its impact on share markets. Asymmetry information does not deeply affect residential property market. In terms to the real state, a buyer is able to collect more accurate information by observing the property directly, and simply analyse the position of the property through comparing it with the similar houses or properties in the same area. Thus, obtaining information about a traded residual property is not difficult or costly as share. In fact, the investor’s decision does not rely on seller’s disclosures solely. Therefore, adverse problems are not capable to grow in this area as much as they do in exchange market.

10 Jun 2021

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