Student Blog Submission : The “Lemons” Problem on the Stock Market

By Clara Wolf

In 1984, the two economists Myers and Majluf published their research on a model about the information content of share prices, which can be regarded as an application of Akerlof’s lemons problem. Their paper mainly concentrates on financial markets and more precisely on firm’s investment decisions. There are information asymmetries as managers hold information about the actual firm’s value that investors do not have access to. So investors are affected by adverse selection. They assume in their model that taxes, transaction costs and other capital market imperfections are negligible.

If a firm has the chance to invest in a project with positive net present value (NPV), it will be interested in doing so. The costs of financing such projects rise with information asymmetry. Myers and Majluf therefore introduce the so called ‘Pecking Order Theory’ which places the financing possibilities in order, starting with the most likely and ending with the most undesired. Accordingly, firms will always prefer internal financing, followed by debt and lastly new equity. If the first two options are out of the question, they will investigate whether issuing new equity is profitable.
If managers think their company is undervalued at the market, “issuing shares at a bargain price may outweigh the project’s NPV”. If investors anticipated this, they would know that the “decision not to issue shares signals ‘good news'”. As a result a firm of high quality misses a good investment and the firm value is reduced. The firm is caught in a “financing trap”. Thus, managers are best advised by reallocating the firm’s capital structure in order to avoid such situations in the future.

However, if a firm believes that their shares are priced correctly or even are overvalued, they will likely be interested in financing with new equity. The result is that the firms of higher actual value avoid the investment and the firms of low quality, the ‘lemons’ in this model, will expand by issuing new shares. Hence, bad firms grow faster and the market will soon be dominated by ‘lemons’.

New markets, e.g. like the IT sector at the beginning of the last century, are prone to such dilemmas since all firms seem to be similar and it is hard to differentiate good ones from bad ones. Starting in the late 90’s many new technology firms appeared on the market. Refreshing ideas in combination with high payoff predictions aroused the investor’s interests. But not all concepts proved to be worthwhile in the long run. Overvalued firms were able to acquire money easily and therefore grew rapidly. This lead to a peak in March 2000, which was followed by a great downfall when investors finally discovered these misvaluations.

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