The Market for Lemons
Why do people prefer buying used cars from a dealer rather than a private seller? Especially when people know they must pay a premium for dealer’s commission charges over and above the car’s selling price.
This is the issue American economist George Akerlof addressed at length in his paper, “The Market for Lemons”. The paper is credited with being one of the first that explored the role that information played in economics.
Markets with asymmetric information
The used cars market suffers from information asymmetry; the seller knows a lot more about the product-quality than the buyer can hope to grasp in a brief inspection.
So, there’s a risk the buyer ends up with a “lemon” (used to denote cars found defective after its purchase). However, just like any other market, there will always be “peaches” too (used to denote high-quality cars).
Due to information asymmetry, the sellers can selectively sell lemons instead of peaches. This is “adverse selection” in action, where one party takes advantage of the hidden information to benefit more from a contract.
Where does this lead the market towards?
According to Akerlof, if unchecked, it can even result in market collapse.
Why is this?
Since the buyers cannot distinguish between a lemon and a peach, they will settle for a price that averages lemon and peach prices.
Naturally, the order will be: Price (Peach) > Price (Average) > Price (Lemon)
This gives the seller both the incentive and the means to sell lemons for the average price (and gain profits). All while keeping peaches out of the market, and exiting when the lemons are all sold.
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Enter the feedback loop. Since it’s lemons that were sold, the word-of-mouth spreads and people will push for lower selling prices. The higher-quality cars are left in lurch, for people’s willingness to pay more for cars has reduced.
It will reach a point when higher-quality cars can only be sold at ridiculously low prices or lower-quality products are all that remain in the market.
Examples of the information problem
The “lemons” concept clarifies why nobly-intended initiatives fall flat when the information problem is not solved.
An article from ‘The Economist’ talks about a new law that banned firms from accessing job applicant’s credit scores. The state of Washington introduced this law to promote equality since blacks and the young were more likely to have low credit scores. Apparently, ten other states followed suit.
However, a recent study revealed that “the laws left blacks and the young with fewer jobs, not more.” To combat information opacity, the firms seem to have defaulted to rejecting blacks and the young altogether, instead of considering each applicant on a standalone basis.
Likewise, there have been calls to ban standardized tests. It’s argued that students from wealthy backgrounds have better means to prepare and succeed.
Sans the standardized tests, as this article points, “more weight is placed on factors like guidance counselor essays, AP courses, and extracurricular activities.” These factors are more likely to further skew the balance in favor of wealthier students.
That said, standardized test scores are indeed problematic for a different reason. Schools that admit students with higher scores in standardized tests signal better student ability. As a result, employers are likely to choose students from these selective schools over all institutions with similar reputation and resources.
Enter the feedback loop. The selective school will attract students with progressively higher scores in standardized tests, thanks to its employment record. Non-selective schools may have to settle for the remaining students, who are less likely to gain employment, thus affecting their reputation as time passes. Over time, selective schools will corner the brightest minds and larger pie in the market.
One last example about the insurance market. Here, the insurance companies are buyers, while the customers are sellers. However, customers obviously know more about their health than the insurer. Therefore, a customer will only buy a policy if the premium is lesser than his expected healthcare costs. If the premium is higher, the customer may not buy the insurance.
Only customers whose premium is lower than their expected healthcare costs will opt in. The adverse selection kicks in. Insurers will end up paying more than the premium. They respond by increasing the premium. In such a scenario, customers whose healthcare expenses are lower than the now-increased premium will exit the policy. The customers who retain the policy are those whose expected healthcare costs exceed the premium. This will adversely affect the insurer’s profitability over time.