The Market for Lemons
George Akerlof’s 1970 paper “The Market for Lemons” is a brilliant paper which gets a bad rap. It’s satirized as “the time economists proved used car salesmen don’t exist”. Sure, but that’s not the point. The point is that to avoid this market failure, people have to very substantially change their behavior — and this explains why the world has many of the features it does.
i. What’s it about
The paper deals with cases where information about a good is known to the seller, but not the buyer. He uses the used car market as an example, but specifics are not so important, however, to the argument, which can be applied anywhere.
The “lemon” in the title is slang for a faulty used car. Sellers would like to sell lemons for the same price as a good car, which they could do only by not revealing the true quality of the car. However, buyers know that some percentage of cars are going to be lemons, and so are disinclined to buy — the price will have to be lowered. Of course, the price being lower disinclines the owners of good cars to sell, leaving an even greater proportion of lemons; and so on and so on. In order to have all beneficial transactions take place, you must evolve standards. You must be able to judge quality, and then someone must be able to enforce contracts.
Let’s take the case of moneylending, which is given as an example in the paper with particular reference to India but could really be about any country. Banks have a hard time telling apart people who are going to run off with the money, or at the very least are undergoing riskier projects, from those who are safe investments. Big commercial banks are able to offer loans where contracts are easily enforceable, like in the cities, but cannot offer them in the countryside. Instead, they are provided within ethnic organizations or by local lender who know their customers extremely well. If the big bank were to naively think they could come to the countryside, they would be fleeced left and right, not being able to tell who would actually pay back. The only people able to make loans are local lenders, who charge extremely high rates. Society would be better off if big banks could make loans in the countryside, but without credible signals, trade won’t happen.
ii. Why it matters
Because all of this is a really big deal in developing countries especially! We evolve institutions to deal with this, but we cannot take them for granted. They come into being through conscious effort, and need not emerge by happenstance. They may need to be imposed or created on the outside.
Second, it is a reason why differences in patience, trust and pro-social behavior can be a really big deal. The merchant who sells poor quality goods is destroying the commons. They make it harder for other merchants to make deals. I don’t think that humans are ultimately constrained by a very mechanistic justice, where they cheat precisely to the extent it is profitable to, and are stopped only by a system of punishment. Our justice systems are inadequate to this, and exist only for unusual cases. No, people are mainly held back from anti-social actions by a sense of what is normal and what is right and wrong to do. In a place where corruption and cheating is the norm, you cannot take the existence of commerce for granted. Institutions must be evolved for it to flourish. In a world where the norms of fairness and trust are so inculcated that people do it for its own sake, you need less in the way of explicit rule-making and enforcement. It is not just error rate, as with the O-ring theory of production, which is the channel for lower human capital to lead to lower output.