Why Markets Exist : Markets promote greater economic activity. If markets are non-existent or inefficient, such activity is simply starved., with consequences for economic development. That holds true for financial markets, goods markets and commodity markets.

George Akerlof won the Nobel Prize in economics in 2001. His paper, ''The Market for Lemons'', is seminal work in the discipline. He wrote it in 1967 as a fresh assistant professor at Berkeley, having completed his PhD at MIT in 1966.

The paper was rejected by three prestigious journals, by two on the grounds of triviality and by the third on the grounds that it would upend the then prevailing understanding of economics. It was finally published by the Quarterly Journal of Economics, in 1970.

The Market for Lemons is about markets and transactions. In Akerlof's own words ''It concerns how horse traders respond to the natural question : 

''If he wants to sell that horse,  do I really want to buy it?'''

Akerlof uses the example of the used car market to illustrate the point in any given market, some cars will inevitably be of bad quality [lemons, in the slang] and some of good quality [peaches].

Any seller, as the current owner of the car, always has better information about the quality and inherent value of the car than any buyer. A buyer contemplating a purchase does not know if the car is a peach or a lemon. Let us say, the fair value of the peach is $20,000 and that of a lemon is $10,000. 

The buyer, under the circumstances, can expect equally to get either  a peach or a lemon and will therefore offer an average of the two prices ie $15,000. At this price the owners of the lemons will be happy to sell but the owners of peach will withhold their cars from the market since the price offered is less than the fair value. There is thus a market malfunction.

We can take it a step further. If a certain number of peaches are withheld by the sellers, buyers will revise their expectations of the average proportion if lemons to peaches and will bid even lower than $15,000. The malfunction intensifies.  The root cause of the problem is of course the existence of unequal information. Economists have a fancy phrase for it - information asymmetry.

Any market malfunction is serious because it results in a loss of economic efficiency - transactions which could have added value to both parties do not happen. In response, markets, - the institutions, rules and regulations which govern them-  have evolved over time to become more efficient with positive repercussions for economic growth and development.

Let us take a leap from the used car markets to financial markets to see this more closely

Financial transactions are highly susceptible to information asymmetries because of their inherent complexity.

Financial markets, for all of  their considerable sins, offer insights into the nature and role markets in general by virtue of their size, scope and sophistication.

Financial markets, at their most basic, provide a mechanism to move money from those who have a surplus to those who have a productive need for money but do not have a surplus. 

Financial markets, as any other market, are a central meeting place for buyers and sellers [of funds]  These meeting places can be physical or - increasingly - virtual.

The Publishing continues to part 2. The World Students Society thanks author Professor Samir Ahmed, a financial market professional.


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