Hello readers, welcome back to this weeks edition of rsira-economics.com. Last week, you might remember me discussing whether robots could ‘steal our jobs’ and the potential economic consequences this would carry with it. Having considered a number of different views from different academics and economists across the globe, it was clear by the end of the post that we are not likely to be headed toward a rise of the machine world or a utopia where no one works anymore; rather it is probable that we could experience something between the two. At the moment the main limiting factor that is restricting robots and their use are the extreme costs associated with them. Further, there is the moral argument looming in the background that how can we rely on machines to do everything for us when humans were born to work, and if robots become more and more human-like, how will we be able to distinguish ourselves from these ‘synthetic creatures’. I left you all with a few questions to think about. Obviously there were no right or wrong answers since we simply cannot predict the future and we don’t have enough information to solve this complex phenomenon, but hopefully, it got you thinking like an economist!
In today’s post, I will be looking at information failure, which is actually another form of market failure, and how this applies to the real world. In the post about ‘carbon taxes and negative externalities’, I addressed a different sort of market failure-the market failure behind pollution, namely a negative externality problem. I focused on the solutions to what was termed as ‘the greatest market failure the world has seen’ and my argument was based on how a carbon tax really was the best solution. This post however will discuss the theory behind information failure and how this applies to the second hand car market. I will keep this post short and to the point and hopefully it will be an interesting theory to ponder over, perhaps during your lunch break. Next week I will be reviewing the recent announcement of The Budget and the economic impacts this carries with it.
‘Akerlof’s Lemon Thoery’
Now you might be thinking about the yellow citrus fruit we all know as, the lemon and wondering how this has anything to do with economics. However, I can assure you that this actually has everything to do with economics. If you were looking for a recipe for a lemon cake or something lemon orientated and happened to stroll across this blog, apologies, but you might want to look elsewhere as this post will be discussing economic issues.
The noble prize winning economist George Akerlof in his 1970 paper, ‘The Market for Lemons’ first proposed the theory behind asymmetric information and he used the example of buying second hand cars to explain it. For those of you who don’t know what asymmetric information is, investopedia have explained it in a nutshell: “A form of information failure, which is present whenever one party to an economic transaction possesses greater material knowledge than the other party. This normally manifests itself when the seller of a good or service has greater knowledge than the buyer, although the opposite is possible. Almost all economic transactions involve information asymmetries”.
Anyway, his theory went something like this:
Suppose we say that ‘peaches’ are good cars and that buyers value these peaches at £10,000 and sellers value them slightly less. On the flipside, a ‘lemon’- a bad car is only valued at £5000 by the buyer and again a little less to the seller. If the issue of asymmetric information did not exist meaning there would be no market failure, the trade in both peaches and lemons would both flourish. However, with economics, nothing is as simple as this and the real world is much more complex than this. In reality, scratches can be covered up, engine problems cannot be declared in the service records and mileage counters could even be adjusted and so buyers can struggle to tell the difference. In order for buyers to compensate for this risk that the car could be a lemon, buyers slash their offers to £7500. Although, any rational seller, who knows that their car is a peach would reject this offer. This gives rise to the concept of “adverse selection”, that is only sellers who will be prepared to accept £7500 are those who know that the car they are selling is a lemon. Smart buyers could foresee this problem and knowing that they will only ever be sold a lemon they will offer a reduced offer of £5000. As a result, the seller ends up with the same price they would have done even if there hadn’t been this ambiguity in the first place, although they keep the peaches separate in the garage. Even though there are buyers out there who would be willing and able to pay the asking price for a peach which they knew was actually a peach, this “information asymmetry” between buyers and sellers kills the market, as buyers and sellers don’t have equal amounts of information required to make an informed decision. This is the basis of Akerlof’s thesis, and if buyers were able to appreciate the qualities of each car, good cars would fetch more money and it should be no more attractive to sell a cheap lemon than an expensive peach.
I was first introduced to this concept in Harford’s book, “the undercover economist” and by doing further research into this topic it is clear that the used-car market hasn’t disappeared, and so economists have debated how much Akerlof’s model really explains the market, nevertheless it is an interesting economics related idea which is worth discussing.
The reason why it is called a lemon theory for those who are still figuring how lemons come into all of this is because Americans use the term ‘lemon’ to describe something which is defective, just like a second-hand car may well be.
So should you buy second-hand cars now that you are equipped with this economics knowledge?
If you didn’t quite understand this post or are still worried about the fact that you could end up purchasing a defective car, it is probably best that you stick to purchasing a new car, providing that you don’t burst the bubble and get yourself into a whole load of debt with ridiculous interest repayments.
However if you’ve understood the fundamental theory, you should still be perfectly able to purchase a second-hand car. Remember though, that this is just a theory and like with many economics theories, the issue is much more complex and does not always hold in the real world.
‘The Undercover Economist’ by Tim Harford