Any colour you like, as long as it’s lemon

22nd April, 2006

The Undercover Economist – FT Magazine, 22 April

I recently did something that is, in theory, most unwise: I bought a second-hand car. Since economists hate to compromise between safety and style, it was a Volvo. You’d think I would know better. The American subtitle of my book is “Why you can never buy a decent used car”.

In 1966, an assistant economics professor, George Akerlof, tried to explain why this is so in a working paper called “The Market for Lemons”. His basic insight was simple: if somebody who has plenty of experience driving a particular car is keen to sell it to you, why should you be so keen to buy it?

Akerlof showed that insight could have dramatic consequences. Buyers’ perfectly sensible fears of being ripped off could, in principle, wipe out the entire used-car market: there would be no price that a rational seller would offer that was low enough to make the sale. The deeper the discount, the more the buyer would be sure that the car was a terrible lemon.

More plausibly, only the market for cheap, shoddy used cars would survive. A person with a good car would hold on to it because he couldn’t prove it was good and so wouldn’t expect an attractive offer for it. And if the good cars aren’t put up for sale, the lemons will be what is left. This is a problem not just for buyers, but for sellers too, who wish they could be trusted.

Economists dispute whether this is actually a reasonable description of the used car market. For instance, there’s been a lively controversy as to whether pickup trucks that are sold second-hand have higher maintenance bills than pickup trucks of the same age that are not sold. (If they do, that’s evidence in favour of Akerlof’s “lemons” model.)

But that is not really the point, because used cars were just the beginning for Akerlof. His neat little paper was turned down by two top journals because they couldn’t see past the trivia of his example. He recalls that a third, the Journal of Political Economy, had a better reason for rejecting him: the paper couldn’t be true, because if it was true then economics would be turned on its head.

The Journal of Political Economy was half right. Akerlof did turn economics on its head – and eventually received the Nobel Prize for doing so – not by documenting the travails of used-car buyers and sellers, but by showing how corrosive a little bit of inside information can be to all sorts of markets. Insurance, including health insurance, is one possible casualty. Loans and mortgages too: some people simply cannot get a loan, no matter how much interest they offer to pay.

Then there’s the market for jobs. How many of your colleagues are lemons? If you’re competent but can’t prove it to your boss, you may prefer to be freelance. If other competent workers think that way, it may explain why you think your colleagues are idiots and they think the same about you.

These problems can be solved, but at a cost. Mortgage companies refuse credit to whole neighbourhoods as a way of cutting out high- risk borrowers. Employees spend years acquiring qualifications with little value other than proving that they’re smart and work hard. And used-car buyers will look for trusted sellers, even if that raises the cost of doing business. I bought my Volvo from my brother-in-law because I thought that would lower the risk of being sold a lemon.

Not only are the solutions costly, they don’t always work. My Volvo lasted less than a fortnight before the clutch burned out: a bitter little lemon after all.

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