Market for Lemons
Back in 2001, economists George Akerlof, Michael Spence, Joseph Stiglitz, won the Nobel Prize for “their analyses of markets with asymmetric information”. They analyzed the core of modern information economics which transformed the way economists think about the functioning of markets.
“Business in underdeveloped countries is difficult”. In his own words, George Akerlof, an American Economist describes how trust can be a crucial aspect of the economy. Much of modern day economics is built under the assumption of a perfect market. In other words, the behavior of a market is predicted assuming all the key resources including ‘information’ to be equal among all the dominant players.
But Akerlof, along with Michael Spence and Joseph Stiglitz were convinced that such a drastic assumption may lead to inconsistencies, which otherwise is not observed in the real market. One important change that became inevitable to overcome these anomalies is to relax the assumption of the market to be information-symmetric, which was leading the markets to the lemon problem.
The Lemon Problem
In his famous 1970 article, “The Market for Lemons: Quality Uncertainty and the Market Mechanism”, Akerlof describes what happens to markets that suffer asymmetric information. Consider a customer wants to buy a new car. Now, when the seller offers the buyer a car of his/her choice, s/he is unable to decide whether the car is a peach (one is a good condition) or a lemon (one which has been poorly treated/repaired) due to the complexity of the car manufacturing process. So, as a bargain s/he would end up proposing an amount which is somewhere near the average of a peach and a lemon. Since the seller is well-aware of the nature of the car, he would be very displeased if the car was actually a peach whereas quite pleased if it is a lemon. If the present scenario exists, then this discourages the manufacturers of peaches and encourages the lemon manufacturers. Ultimately, the market is left with nothing but lemons. The problem of adverse selection faced by the customers turns to a bane for market efficiency.
Source: http://blog.toyotaofclermont.com
Consider the case of a company which seeks to increase its workforce. It plans to recruit new workers but with a lower salary to compensate for the extra monetary load. Thereby, it conducts interviews for recruitment. An interviewee happily accepts the lower income. The managers of the company are happy. But should they be? Clearly, an efficient worker would be displeased at a lower salary. So, the only possible explanation for the enthusiasm of the interviewee is being a lemon — which clearly the company does not want.
Solutions to the Lemon Problem
Now, it is necessary that this lemon problem is solved. Else, as Akerlof argues in his article, there are cases in which the market would completely disappear due to overwhelming information asymmetries. The gravity of this problem has made this a very trending topic among modern economists. Some solutions are enlisted below:
Providing the buyers more information: Clearly, the most obvious solution was to provide more information to the buyers to help them buy the commodities without any doubts. One way to go about doing this is to provide the customers with an authentic track record of the dealers so that they can buy goods from the dealers with a cleaner record. This would also serve as a positive driving force among the manufacturers to manufacture more peaches, in order to maintain a better record. This simple solution has paved the way for many successful start-ups in the past two decades like Online Hotel Reviews, Fruit Sticker Companies, etc. For instance, what is the most obvious metric for any of us to know if a particular restaurant is good or bad? — Zomato!
While industries like food, hotel, and a few others might have a lot of companies working on gathering data, the market is still open for many others. Whilst Big Data being a grossing concept, markets would love to see more companies focussing on collecting tons of reliable data about dealers ranging from small shops like the local grocery stores, salons and all such petty shops that impact much of our daily lives. Google did attempt to collect such a dataset by collecting reviews for every place offering some service on its map, but however, it is not a widely accepted metric to adjudge a service.
Guarantees and Warranties: Though obtaining relevant information about a dealer enhances the risk ability of a customer, a formal assurance from the firms would make things a lot easier. Such assurances are called warranties, wherein the firm guarantees the customer to take responsibility on an ad hoc basis. Thus, the provision of warranties benefits both the firms, as well as the consumers alike. Introduction of warranties boosts the firms to create as many peaches as possible to avoid loss.
Expert Verification: The support of a product expert/popular figure to the commodity encourages the customer to buy the associated commodity without having to worry about it to turn out a lemon. An indirect consequence of the support of a popular figure is the Bandwagon effect, wherein it will create a hype among the customers to purchase the commodity. A prominent forum which helps experts connect with the customers is YouTube. In the past decade, YouTube has witnessed the rise of several experts in various fields who have their own channel, which helps develop an important interface between the customer and the experts. Needless to say, this enhances the risk tolerance among the customers.
Government laws: Government policies directly affect the economy. No evil can propagate in the economy if the government has a strong hand on it. A smart government would declare several laws to solve the lemon problem in the economy. It can set several industry standards wherein products not satisfying the minimum consumption standard would not be permitted in the market. In extreme cases, it can declare liability laws wherein lemon manufacturing companies would be penalized if their products enter the market. Licensing of manufacturers can be ensured in order to prevent the entry of unauthorized products in the market. Also, the government can draw a rigorous customer protection regulations to ensure the consumers are in no way wronged.
Source: http://blog.aisinsurance.com
Undoubtedly, this lemon problem is too interesting a topic, that it opens up many opportunities for new startups to go about solving it. As Akerlof states,
“The difficulty of distinguishing good quality from bad is inherent in the business world; this may indeed explain many economic institutions and may, in fact, be one of the more important aspects of uncertainty.”
Compiled by Ashish Menon, Senior Executive, Team Ecell
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