One of my new favourite things: The Economist has been publishing a series of weekly ‘economics briefs’ that deal with some of the big ideas that have shaped economic theory. They’re about four weeks in now – but the first brief dealt with information asymmetry, and Nobel prizewinner George Akerlof. Incidentally, George also happens to be the spouse of Fed Chair Janet Yellen. I didn’t know that before – but there we are.

If you feel like reading his paper, check it out here: The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. But be warned: it starts getting wordy with ‘probabilities p and q, which is (1 – p)‘ very quickly.

Some extracts from the opening paragraphs:

From time to time one hears either mention of, or surprise at, the large price difference between new cars and those which have just left the showroom. The usual lunch table justification for this phenomenon is the pure joy of owning a “new” car. We offer a different explanation. Suppose (for the sake of clarity rather than reality) that there are just four kinds of cars. There are new cars and used cars. There are good cars and bad cars (which in America are known as “lemons”). A new car may be a good car or a lemon, and of course the same is true of used cars.

The individuals in this market buy a new automobile without knowing whether the car they buy will be good or a lemon. [But after] owning a specific car, however, for a length of time, the car owner can form a good idea of the quality of this machine.

An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers. But good cars and bad cars must still sell at the same price – since it is impossible for a buyer to tell the difference between a good car and a bad car.

And it’s at this point that the market faces a conundrum:

  1. Let’s say that the owner of the barely-used car knows that the car is good. If he paid R300,000 for it, he wouldn’t really want to sell it for much less than that.
  2. But if he knows that the car is a lemon, he’d be prepared to take less than that (say R200,000). But he’d prefer to take R300,000 if he can get it.
  3. The buyer can’t tell the difference between a good car and a bad car – but he can buy a new car for R300,000. So he’s not about to risk R300,000 on a used car if he can get a new car for the same price.
  4. The buyer might be tempted at a price tag of R200,000 – but at that price, the only time a seller would accept that price is if his car is a lemon.
  5. So you end up with a market for used cars where the only cars being sold are lemons.

Here’s a youtube clip.

Of course, in practice, we deal with asymmetric information by re-balancing the symmetry – and making it possible for buyers to know the difference between good cars and bad cars. So in South Africa, you have certified pre-owned vehicles for sale by the branded car dealers, as well as specialised car re-sale services offered by the AA. Those obviously tend to sell for more than private car sales over gumtree, but that’s the cost of a market solution.

This is not my first foray into the world of asymmetric information. Older posts:

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.