If you have ever purchased a used item from a stranger, you would have probably worried about whether s/he was telling you the whole truth about it. Perhaps you would have had the thought: “The seller knows a lot more about the item than I do. Is it any good? Why does s/he want to sell it? Is it the right price? Am I being fooled?”
Trust is a crucial aspect of the economy. You may have learned that the general school of thought in the economic community largely lent on the single model of perfect competition that is the behavior of a market is predicted assuming that all the key resources including information is equal among all the dominant players.
However, Nobel prize winner Akerlof, along with Michael Spence and Joseph Stiglitz, three brilliant economists, were convinced that the real market is not characterized by such a drastic assumption or it would collapse. They felt the need relax the assumption of the market to be information-symmetric, and came up with a phenomenon called the Lemon Problem. You may be wondering why lemon. Wait there are peaches too. Let me explain.
Consider a customer who wants to buy a second hand car. Now, he is unable to decide whether the car offered to him is a peach (a peach is an immaculate high-quality car) or a lemon (a lemon is dodgy, defective car) since both peaches and the lemons sell at the same price, and so it becomes impossible for a gullible buyer to tell the difference between the lemon and the peach. Only the self-interested seller knows the truth. The mere existence of lemons subsequently drives out the peaches from the market, since the buyer is unwilling to pay the price of a peach, fearing that s/he will end up with a lemon. And no owner of a peach will want to sell his/her superior quality car at the price the consumer is willing to pay for a lemon. Consequently, the sellers of peaches are deprived of any decent offers for their pristine cars thus driving them out of the market. In turn, the quality of cars in the market degrades, causing the cycle to repeat until the point in which only the lemons remain. The market thus fails to produce mutually beneficial trades and collapses. As Akerlof writes in his paper, titled 'The Market for "Lemons": Quality Uncertainty and the Market Mechanism',” You might expect that the sellers would benefit from inside information, but in fact there are no winners: smart buyers simply don't show up to play a rigged game."
So, what does the lemon problem have to do with buying complex services versus used cars? The simplest answer is trust, or perhaps the lack of it. You can take this idea of asymmetrical (lopsided) information and apply it to any market. The lemon problem is prevalent in the financial sector. For instance, in corporate finance, a lender has less than ideal information regarding the actual creditworthiness of a borrower.
In the health insurance industry, buyers have more information because they know how healthy they are but the insurance companies don’t. Insurers may raise their prices because they infer that most of the buyers, who they attract and whose health is not fully known to them, may be sick. But in raising the costs for providing an insurance cover, they will price some of the healthy and desirable potential customers out of the market.
In the labour market, let’s say there is a company which plans on recruiting new workers but with a lower salary to compensate for the extra monetary load. It conducts interviews for the same and an interviewee happily accepts the lower income. The managers of the company are happy. But should they be? Clearly, an efficient worker would be unhappy with a lower salary. So, the only possible explanation for the interviewee’s excitement is him being a lemon, which the company clearly would not want.
Now, it is necessary that this lemon problem is solved and information asymmetries are whittled away. Else, the market would completely fail. In order to preserve market efficiency and protect the needs of both sellers and buyers, some sort of mechanism is necessary; think pre-purchase warranties, guarantees or consumer protection regulations.
The simplest solution is to help gullible customers to buy commodities without any doubt by providing them with more information. This can be done by providing them with an authentic track record of the dealers so that they can buy goods from those with a cleaner record. They would thus be incentivized to manufacture more peaches, in order to maintain a better record and rating. This simple solution has paved the way for many successful start-ups services in the past two decades like AirBnB, Ola, Uber, Oyo etc. What is the most obvious metric for us to know if a particular restaurant is good or bad? Zomato!
Another common trick to defeat the lemons problem is external experts. We often rely on expert advice to help us navigate the market without having to worry about our purchase turning out to be a lemon. But be heedful because these too can be misleading sometimes. For instance, there have been various cases of brokers defrauding customers predominantly in the real estate market.
We are slowly progressing towards a world that will be taken over by artificial intelligence. Slowly, intelligent machines will replace humans and become participants in the market. These machines have larger logical capabilities than humans, and can access and digest large amounts of information. Hence, an assumption that we can hold is that Artificial Intelligence is making markets more quality oriented because of its ability to detect fake and sub-standard products thus making it difficult for lemons to exist in the market. With it, markets will be rational and largely free of biases and perceptions that human beings are characterized by. The traffic of transactions that will take place in such a market will be greatly reduced due to the reduction in information asymmetry.
So the question is, will there be no market for lemons in the future? Some say that they the lemon problem no longer exists since warranties, expert advisers, and government consumer protection laws are already in place. The advent of new technologies has also solved multiple market failures by narrowing the information gaps in various economic exchanges. But always remember that whenever you are unable to fully assess the things you are purchasing, there is always a chance you are going to get a lemon. So if you ever wonder why your supplier is not innovating, perhaps it is because it is in a race to the bottom of the market because the best suppliers ultimately run out of business or reduce their quality to compete. Then you are definitely dealing with lemons.
Neha Dagade
References:
1. George Akerlof and the Lemon Problem
2. Market for Lemons - Noteworthy - The Journal Blog
3. No market for lemons: artificial intelligence and the markets
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