Testing the Theory: New Research on Asymmetric Information

By Cassi Ainsworth-Grace

Proposed by George A. Akerlof in his influential paper, The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism, the concept of asymmetric information has been a staple in the education of Economics students since 1970. Yet, a new study conducted in September by Richard Blundell, alongside four other co-authors, has challenged asymmetric information’s foothold in the university curriculum by examining the extent to which lemons are in fact an issue.

The existence of products with varying degrees of quality is the fundamental problem posed to the theory of markets. Further complicating the issue is that consumers are, more often than not, presented with products whose quality is not only difficult to judge, but is sometimes completely unknown. Although standardization of goods by big name brands like McDonalds and Starbucks has offered a solution to overcoming the uncertainty over quality, consumers are still too often left in the dark.

To explain his theory, Akerlof allegorized the sale and purchase of second hand automobiles. Breaking down the market into two different types, Akerlof segmented the used cars into those with no defects; peaches, and those with hidden defects he dubbed lemons. In an entirely transparent world with perfect information, trade would operate perfectly, for consumers would possess complete certainty as to which of the cars were lemons.

In practice yes, but the world is not perfect. In reality, sellers naturally have more information about the quality of their car than the buyer. Both the peaches and the lemons sell at the same price, for it becomes impossible for a buyer to tell the difference between the lemon and the peach, when only the self-interested seller knows the truth. Subsequently, the mere existence of lemons drives out the peaches from the market, for consumers are unwilling to pay the price of a peach, in the fear that they will end up with a lemon. Thus, we are left with a market of only lemons, for no owner of a peach would sell their superior quality car at the cut price the consumer is willing to pay for a lemon. In this situation, the buyer faces the asymmetric information problem of ‘adverse selection’, as only sellers of lemons will accept the lower offer, resulting in the price they would have received in a world with complete transparency. Only the market does not exist for peaches, and thus it follows that there is no real market for second hand cars.

The theory explored in this paper earned Akerlof the Noble Memorial Prize in Economic Sciences in 2002, alongside Michael Spence and Joseph Stiglitz. Yet, Blundell’s research, published September 2019 in his paper Durables and Lemons: Private Information and the Market for Cars, challenges this established theory. The analysis was conducted by measuring the impact of the ‘lemons penalty’ on the sale and purchase of new and second-hand cars in Denmark by measuring the depreciation on the sale price of used cars over time, then calculating how big a discount was incurred.  

The results show clear evidence of the market failure as proposed by Akerlof, as a lemon penalty of 18% was incurred in the first year of ownership, followed by 8% in the subsequent year. The effect, however, decreases over time, with the lemon penalty vanishing by the ninth year of ownership. Blundell suggests that if the car is sufficiently old, dealers do not have to be fearful of those hidden defects, as the faults of the car become exceedingly obvious. They conclude that, instead, there does exist a market for cars of differing ages.

In addition, the lemons problem can be addressed through collecting additional information that diminishes the imbalance of information between buyer and seller. For example, through independent third party examinations, like hiring a mechanic to inspect the vehicle, one can come closer to concluding whether the car is a peach or a lemon. If the buyer can obtain enough information through such methods to make an educated purchasing decision, the product quality industry-wide can increase, and thus the aggregate satisfaction of consumers. 

The risk associated with purchasing in a market like the second-hand car industry can also be passed to the other party. Guarantees like a 3 year warranty for a product passes the risk of the product being a lemon to the seller, who guarantees the product in case of its breakdown. This simultaneously incentivises the seller to improve the quality of their product to avoid such a scenario. Furthermore,  the development of firms like webuyanycar.com passes on the entire risk of the purchase to another, although it must be noted, not solving the lemons problem.

While Akerlof’s paper predicts that the lemons penalty will see many buyers turned away, Blundell and his fellow co-authors have observed clear limitations with this theory. As the car in question grows older, the lemon penalty eventually disappears as it approaches zero,  evidence that the testing of well-established economic models may render a result that differs from the one predicted.

 

Bibliography

George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism (August 1970), The Quarterly Journal of Economics, Vol. 84, No. 3, pp. 488-500. 

The Economist, The juicy market for lemons: Can you buy a good second-hand car? (26th September, 2019), <https://www.economist.com/finance-and-economics/2019/09/26/can-you-buy-a-good-second-hand-car>, [Accessed 29th September, 2019]

The Economist, Information Asymmetry: Secrets and Agents (23rd July, 2016), <https://www.economist.com/economics-brief/2016/07/23/secrets-and-agents>, [Accessed 30th September, 2019]

Richard Blundell, Ran Gu, Soren Leth-Petersen, Hamish Low, and Costas Meghir, Durables and Lemons: Private Information and the Market for Cars (September 2019), Yale University  

Barclay Palmer, What a “Lemon” Product is, and How to Avoid Purchasing One (22nd February, 2019), Investopedia, <https://www.investopedia.com/articles/pf/11/solutions-to-lemon-problem.asp>, [Accessed 3rd November, 2019]

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