The concept of adverse selection and its implication for the functioning of the market were first discussed in a seminal paper by the Economics Nobel Prize winner George Akerlof. This paper is titled 'The Market for "Lemons": Quality, Uncertainty, and the Market Mechanism. In this paper Akerlof talks about the market for second hand cars. Akerlof makes the point that a second-hand car dealer has some information that an inexperienced customer interested in purchasing a second-hand car does not have. In this case, an inexperienced buyer would not know if it a second-hand car is a good car (or what we call a peach) or a bad car (known in the trade as a lemon), but the salesperson of course does. The inexperienced buyer is probably aware that he is not sufficiently knowledgeable about a second-hand car, so we might not trust a salesperson trying to convince him that the car is a good one. Such a situation is problematic for both parties in the transaction, not just for the buyer. Indeed, if the buyer gives up and does not buy the car, no transaction takes place and no surplus is generated. This is a problem of asymmetric information. Consider the following numeric example. Our inexperienced buyer is willing to pay for both a lemon and a peach, but he is willing to pay more for a peach. Say, that he is willing to pay 1000 euro for a lemon and 2000 euro for a peach. Similarly, the seller is asks a value of 900 euro for a lemon and 1800 euro for a peach. Please take note of these numbers now. In this example, exchange of either a lemon or a peach generates surplus. In the case of a lemon, the surplus generated is a 100 euro. This is calculated as the difference between 1000 euro, the value of a lemon to the buyer, and 900 euro, the value of a lemon to the seller. Similarly in the case of a peach, the generated surplus in the exchange is 200 euros. This is calculated as the difference between 2000 euros, the value of a peach for the buyer, and 1800 euro the value of a peach to the seller. This means that exchange of either type of car generates surplus. You might know a situation in which both the buyer and the seller can distinguish a lemon from a peach. This is a situation without informational problems and the outcome will be as follow: Both type of cars, peach and lemon, will be exchanged. The price of a lemon will be between 900 and 1000 euro. That is between the value of a lemon to the seller and the value of a lemon to the buyer. The price for a peach will be between 1800 euros and 2000 euros. That is between the value of a peach to the seller and the value of a peach to the buyer. Now consider a situation with asymmetric information in which only the seller knows if the car he wants to sell is a lemon or a peach. What will the buyer decide to do? At first the buyer might be, for example, willing to pay 1500 euros. This value is between what he is willing to pay for a lemon and what he is willing to pay for a peach. And this value reflects his uncertainty regarding the quality of the car. But if the buyer thinks this through, he might have some 2nd thought. The buyer might figure out that the owner of a peach is not going to sell his car for 1500 euros. Indeed, by selling the car the seller gets 1500 euros, but his value of owning a peach is 1800 euros. It is not worthwhile for the owner of a peach to sell his peach for 1500 euros. Vice versa, the owner of a lemon will be delighted to sell his lemon. By doing so he gets 1500 euros. but his value of owning a lemon is only 900 euros. This is a good deal for the seller of a lemon. This is precisely the adverse selection problem. Ultimately the buyer will realize that he is getting a lemon for 1500 euros. He would then be willing to pay at most his value for a lemon, which is 1000 euros. To summarize: the outcome in the presence of asymmetric information is the following: Only lemons are sold in this market. There is no market for peaches, although the exchange of a peach would generate more surplus than the exchange of a lemon. Recall that the surplus from a peach in our example is 200 euros, while the surplus from exchanging a lemon is only 100 euros. This is called a market failure: a situation in which the market outcome differs from the outcome with the highest possible surplus.