The buyer’s willingness to pay is based on the value (or utility) he thinks he will get from engaging in an economic transaction, i.e. purchasing a product or service. On the other side, you have the seller whose willingness to sell, i.e. the amount of money he requires to sell a given product or service, depends on what he thinks the buyer’s willingness to pay is, but also he needs to think that he would be better off by selling this product than keeping it.
The entire idea behind the market economy is that both the buyer and the seller can become better off by engaging in an economic transaction -- in fact, this is a prerequisite. If either party would be worse off by completing the transaction, why on earth would they?
In some transactions, however, there is a great deal of uncertainty around the utility one of the parties (or both parties) will get from completing the transaction: take insurance companies, for example. Should they sell a car insurance policy to you? And what should the price be?
It depends on how likely you are to damage your car, right? In theory, you could deliberately drive your car into a tree on your way home from the insurance office, and it would immediately become a very bad deal for the insurance company; i.e. they would have been better off by not completing the transaction.
Similarly, when you buy a used car, the owner knows much more about how much value you get than you do, making it much harder to estimate whether you would be better off completing the transaction or not.
How Willingness to Pay & Willingness to Sell Form Under Asymmetric Information
George Akerlof famously referred to the used-car problem as the market for lemons. While the buyer can get some idea of the value of the car, for instance by seeing it before purchasing it, requesting certificates, etc., there is still a great deal of uncertainty: he could both be making a bad choice or get a bargain car!
Due to this uncertainty, the buyer will assume that he gets a poor car (a lemon) when deciding what to pay: if he gets a poor car, he will still get a little utility from the transaction, and if he gets a great car, he will have made a bargain; in that way, he creates a win-win situation for himself.
But what happens when the buyer’s willingness to pay is based on the expectation that you get a poor car? The sellers of great cars in the market will stay away -- if you have a great car, but can only get the price of a poor car, i.e. a price that is lower than your willingness to sell, then they won’t benefit from the transaction.
The result is a market for lemons, where only those with poor cars will engage in the transaction.
Most Firms Don’t Sell Lemons
The problem is that most firms don’t sell lemons. There are a significant number of firms that sell really good products, but find it hard to sell their products due to the existence of information asymmetries. In order to drive up willingness to pay in this case, eliminating the asymmetric information is vital.
If you, as the seller, possess the asymmetric information, then you will need to give certain guarantees or provide transparency to the customer -- remember, if you’re not selling lemons, this will be good for business. For example, Envirofone (selling refurbished and used electronics devices such as iPhones) provides a 1-year warranty, 14 days return, and they use an external, objective provider to assess the condition of the phones that they sell. Envirofone’s sales are booming because they take away information asymmetries from a market that traditionally been a market for lemons.
Similarly, if your customers possess this information, it is your job to make sure to get guarantees and transparency -- it’s in your own interest! The reason is that your willingness to sell to some people will be too high, and you will miss a great deal. For example, an insurance company that bases its rates on the worst possible drivers, the most unhealthy patients, etc., will charge prices that are too high to those that are in good health and drive safely -- thus, these types of customers will be unwilling to pay your high prices and not buy from you.
If you’re in a lemons market, this is a great opportunity to grow!