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The Market for Lemons (wikipedia.org)
82 points by Ibethewalrus 41 days ago | hide | past | web | favorite | 44 comments

Interesting, but there seem to be a lot of assumptions baked into the default "used car market" example, that don't necessarily hold up. For example, the idea that the owner knows whether they hold a "peach" or a "lemon". Clearly he/she has some idea, but they definitely do not have perfect knowledge of this. In fact, this very lack of knowledge ("how many more miles will I get out of this car before the transmission falls out?") may be the reason the owner has chosen to manage risk by buying a newer car. But the actual answer to that question could be anywhere from "1 more mile" to "another 250,000+ miles".

Likewise, this statement:

Given the fixed price at which buyers will buy, sellers will sell only when they hold "lemons" (since plemon < pavg) and they will leave the market when they hold "peaches"

is iffy. As the owner of a used car, I may choose to buy a newer car for any number of reasons, including just wanting something to impress my peers, or impress members of the opposite sex, whatever. Say I buy a nice, sexy, new sports-car. I don't need my old car anymore, regardless of whether it is a peach or a lemon. But my decision to sell it may not involve its status as "peach" or "lemon". It may simply be that I don't want to pay property taxes and registration fees on a car I'm not using. Maybe I just don't have anywhere to park a second car. Or maybe I'm just feeling generous and want to help somebody else out by selling them my no-longer-needed car.

All of that said, I'm sure the math is valid and this theory has uses... but this used car thing feels a little dodgy.

It's a model. A pretty good one, since the mechanism at play here can occur in a very general sense. The car market is an example where this effect may occur, as is insurance and finance. However, in reality, there are many more things going on that this model abstracts from. Nevertheless, the basic issue of asymmetric information shown in this model exists, to some degree, among other effects. You should not understand this paper as a statement about the used car market.

So for example: You say the owner does not know whether it is a lemon or peach. Well, the model is about asymmetry. Everything goes through if the owner (on average) knows MORE than the buyer. I think that's pretty fair, and if it is not the case, we are not dealing with an information asymmetry and the model is silent on the matter. Similarly, clearly cars are not just two types, lemon and peach. But again, results will hold if you make introduce more and more classes. It just makes the math less simple.

You also say that some people do not sell their car because it is a lemon. True. But again, on average, the rate of lemons for a given price will be higher than it would be if you could identify the quality of a car exactly - because it is sufficient that some people sell their lemons as peaches. You could introduce all this in the model, you just probably wouldn't learn anything new.

It's a good model, because its simple and even if you throw more stuff at it, the mechanism persists to a degree. Clearly, in reality, more things are going on than just this. But reading the paper we learn about an issue that exists within the complex system, and that is valuable.

But reading the paper we learn about an issue that exists within the complex system, and that is valuable.

Agreed, that why I said "All of that said, I'm sure the math is valid and this theory has uses." My criticism (if you want to call it that) isn't of the fundamental, underlying theory... it's more with the specific example chose to illustrate it. I suspect that there is a better example model they could have chosen.

A lemon is not a car that is about to have major problems, but one that has had many problems in the past. The current owner knows if they have a lemon or not.

Knowing if you have a peach or not is more complex, but as the owner of a 10 year old car that has had nothing go wrong with it, I a reluctant to sell it despite being able to afford a much newer car - why take the risk of getting a lemon when I can just keep driving my current car.

A lemon is not a car that is about to have major problems, but one that has had many problems in the past. The current owner knows if they have a lemon or not.

Sure, to some extent. Anyway, all I'm saying is that this example is less clear-cut than the authors make it out to be.

Just to drill into this a little more: say a person has a 10 year old car, that has needed a timing belt and a water pump in the last year (but no major problems before that). Is that a lemon? Arguably. Or it could just be a 10 year old car that's needed two of the common repairs required of cars as they age. Is it going to need more major repairs soon? Hard to say. It could be that the low-hanging fruit have been picked off now, and that it's going to be fine for several more years.

Knowing if you have a peach or not is more complex, but as the owner of a 10 year old car that has had nothing go wrong with it, I a reluctant to sell it despite being able to afford a much newer car - why take the risk of getting a lemon when I can just keep driving my current car.

Sure, but if everybody thought that way, nobody with a functioning car would ever upgrade to a new car. And we know from observation that that is not the case. People buy new cars for all sorts of reasons, and quite often they sell their old car as a consequence.

This also ignores the fact that there are signals a buyer can use that correlate to the quality of the used car, even if they aren't perfect indicators. Mileage and year, for example. And price discrimination based on these factors obviously takes place. It seems clear that there is a market for used cars across a varying continuum of "goodness".

The concept of information asymmetry doesn't apply at all to year of car (buyer and seller agree on that fact based on title and VIN) and largely doesn't apply to mileage (barring odometer rollback known only to seller or "total mileage unknown" brand on the title which is relatively uncommon).

The concept of information asymmetry doesn't apply at all to year of car (buyer and seller agree on that fact based on title and VIN) and largely doesn't apply to mileage

That's exactly my point. The apparent information asymmetry regarding the overall "goodness" of the used car, is mediated by the presence of strong signals about that goodness, which are available to all parties. Note that I'm not saying they eliminate the overall asymmetry, just that they reduce it.

Imagine there were two places to sell used cars. For example a dealer, where buyers could take it for a test drive, and auction, where you see it and have to bid on sight alone.

In such a situation, the lemons would gravitate to the auctionhouse, while the peaches end up at dealers.

The model isn't about cars, used or otherwise.

The example is used for illustrative purposes.

The model makes sense within the limited domain of its assumptions.

I find it weird though that it uses an example of autos, because of the hypothetical presence of asymmetric information, which doesn’t seem to describe the real world well at all.

The quality of cars has risen dramatically and steadily over the years. There are multiple mechanisms which compensate for the difficulties a lay person has valuing a complex product.

In addition to government regulations, brand reputation is hugely important in motivating automakers to make reliable products.

The subject is of keen interest to buyers, who actively seek out information about potential quality of a new car purchase. In the pre-internet area it was harder, but sources of information like Consumer Reports were well used.

Since brand perception is expensive to build, and easy to lose, my anecdotal perception is that automakers try really hard to make great products. Especially because if the sell someone a lemon, the customer will be stuck with it for some time, increasing the opportunity for various types of reputation harming communication.

In the used car market the forces that drive quality are passed right through. While there is perhaps a higher chance of being stuck with a lemon, there are plenty of countervailing forces.

In anycase it struck me as odd that the example the paper used to show the intuition behind it was one that my perspective is almost the opposite of.

I guess the general principle I’m alluding it is that in markets that have a high potential for asymmetric information problems, the problems are obvious, and potential buyers will actively use strategies to compensate.

The whole point of the model is that whilst Consumer Reports etc can tell you that a brand of car is typically reliable, they can't tell you which individual cars are and aren't up to the usual standards. That's the information asymmetry, not just the average person knowing relatively little about cars. And since people try to get rid of the substandard individual cars earlier than the reliable ones (and the resulting lower price of used cars because they're often substandard makes people even less likely to sell good examples), you end up with a disproportionate part of the used car market for, say, Toyotas being made up of the relatively rare examples of Toyotas with build quality issues. Nobody's denying there are also market forces that encourage manufacturers to work on quality control, but forces which make "lemons" disproportionately prominent on the used car market exist unless and until the entire production run is defect-free.

Cars were probably chosen as the example because they are and were the most prominent example of a market for second hand goods, and one where non-obvious differences in quality between individual examples of the same product obviously matter.

It seems like you failed to recognize that the example uses market for _used_ cars as an example. You are thinking market for new cars.

Lemon market conditions are quite common. Averse selection is now seen as a fundamental cause of market failure. For example corporate securities markets, insurance markets, virtually all resale markets and housing markets specially suffer from the adverse selection to some degree.

It is hard to tell if _used_ car A is better than _used_ car B. For example: did the owner change the oil regularly?

Other examples:

- How do you know if that used sofa online has bed bugs?

- This is also why people that was fired (even for reasonable reasons) has more trouble finding a job -- you don't want to end up with a lemon. "Peaches" are less likely to be fired.

- This is also why people like explanation such as "selling because I am leaving the country" -- it gives them a reason to believe your car/mattress/pressure cooker it is not a lemon.

The paper was written in 1970. The car market today is drastically different to the market then.

The point of the paper is not 'cars', it's 'information asymmetry'.

Yeah, there's a Twilight Zone episode about a used car salesman... Bit of a caricature but makes it clear how that profession was perceived a few decades before CarMax, Carfax, or the proliferation of consumer warranties.


That said I've recently driven reputable brands that have weird problems dealer mechanics can't even figure out. You can have bad cars with strange problems even today.

The paper isn't about cars.

Hidden information? I made it crystal clear what the car was.


This explains the way consumer app markets go.

App stores cause downward pressure on average prices of apps. Free now being most common.

This drives away high quality app developers where the consumer and the business interests align.

Now there is only a market for user hostile, free consumer software due to this feedback loop reaching its end.

The marginal cost of software is always going to be 0. It just doesn’t take any resources to produce another copy.

As such I think copy right ruined it. Instead of building up an economy of free software and services we tried to build an economy of intellectual property.

Actually, in software, this problem is solved with free trials, pay-per-use, subscriptions, in-game-payments etc. which allows the buyer to pay only for peaches.

So no one makes money from software nowadays?

Some do, if they can find a way to survive or avoid competitors with cheaper/free offerings that are ad-supported or subsidized by VC money.

I wonder if there's a tipping point in information asymmetry where the theory becomes irrelevant. Sellers will almost always have more information than buyers about a specific instance of a product, but there comes a point in a market where buyers have ENOUGH information to avoid buying a lemon, and so can adjust their offer based on that information and disrupt the feedback loop that drives peach owners out of the market.

As an example, you probably could have done very well for yourself in 2009 buying mortgage-backed securities that didn't include any subprime loans. The securities may have had other problems, but at some point there was enough information available to stop buying the lemon securities for subprime loans and pay a bit more than p.avg for the security if it wasn't backed by subprime loans. Information asymmetry still exists, but there's enough information available to avoid making a catastrophic purchase.

So it's almost like the market for lemons is forced to self-correct, because the quality of the product in the market will necessarily drop until it becomes obvious to the buyers what attributes distinguish between a lemon and a peach.

So maybe the chief lesson in The Market for Lemons is if it looks like a market is all peaches, you shouldn't buy anything at all until you've found a few lemons, and there's money to be made in that market if you can distinguish between peaches and lemons before anyone else.

So is information asymmetry really just a market opportunity for a savvy buyer?

> So is information asymmetry really just a market opportunity for a savvy buyer?

Of course it can be (the savvy buyer is the one who's not suffering from the information asymmetry to the same degree) provided you're either not expecting to resell or expect the information you're acting on to be more widely available when you resell. If you can reliably identify a particular car hasn't got a particular issue its model is notorious for by knowing what to look at, you'll get a better price, assuming at least some people owning examples of the car without the issue still sell their cars. If you've got a better risk model, you'll be able to profit from loans other institutions won't make. If you've got a better hiring process, you'll get staff who will accept lower wages and stick around for longer because other potential employers underestimate them.

But not always. If you're in good health and well aware of it, you're still going to overpay for your health insurance because the insurance company can't perfectly evaluate your risk (conversely the health insurance is still a good deal if you're in poor health even if you're entirely ignorant of your mounting health issues). And sometimes the difference between a lemon and a peach just isn't going to be evident until after the purchase.

Buying things on Amazon seems like a similar problem, multiple third parties, cheapest price, fake reviews or different versions being grouped together under one set of reviews

Amazon is clearly not a lemon market (and by clearly I mean it's a textbook case). Amazon is a company that guarantees/warrants the products (buyers have effective recourse to return products). In the paper's model this prevents a lemon market.

Still, I feel more and more annoyed using it because I can't trust the quality. A warranty is still annoying when dealing with low cost items

I think that the presence of effectively meaningless warranties is ripe for exposure.

Unlimited replacements for a $40 screen protector? Just send us $20 to ship you the free replacement.

Business relies on government for enforcement of contract and commercial law, but simultaneously creates intentionally confusing terms and fights against the authority of government to enforce the other side (for the consumer).

In addition to the information asymmetry, there's an overall power asymmetry -- both need to be addressed.

In the US, yes. Otherwise the goods will be shipped from other countries and it will often be impossible to return them or get refunds. Amazon does as little as it can get away with there.

This is not by accident, since most people then choose the shipped&sold by amazon itself, of course potentially more expensive.

The first thought I had when reading this was that this can apply to some online dating apps.

It does.

Seriously speaking, asymmetric information and signaling is the one thing that four-year undergrads in Econ know that's a superpower because ordinary people don't.

I would also say that market conditions for lemons also applies to the job application process since quality signaling through a resume is still pretty hard.

"Examples given in Akerlof's paper include the dearth of formal credit markets in developing countries, and the difficulties that the elderly encounter in buying health insurance"...may someone please shed some light on these two?

The insurance one is pretty straight forward. Somebody with a history of shunning insurance that changes their mind may have done it for abstract reasons (people my age probably should have insurance), or concrete ones (I am feeling a pain in my chest regularly).

If the latter can avoid being accused of having a pre existing condition, by avoiding formal diagnosis for some after signing up, they'll be an incredibly bad deal for the insurance company, and even a small minority of them in the mix of those seeking insurance will greatly increase costs.

It also applies to anyone ratcheting up their coverage.

So why don't insurance companies ratchet up prices to cover the higher costs? Because that'll actively filter out the first class of customers, leaving a higher mix of people that are pretty sure something is wrong with them.

If a decade of fighting cancer costs $5 million, anyone willing to pay $50k a year for insurance for that almost certainly knows something you don't.

Ad absurdum, you'd end up pricing your insurance at a fixed fee of $5 million up front, plus profit margin :)

For that reason, companies may just completely opt out of care for that cohort.

I think this applies not only to Markets but also to something like Politics and Politicians ... "the bad drives out the good."

This theory breaks quickly when seller or buyer needs to do transaction urgently for many possible reasons.

There was a guy (in a city I used to live) who drove by a Porsche he likes and asked how much? Lady asked him if he wants to see other cars. It happened that her husband just died and she wanted to get rid of his estate worth of luxury cars that she hated. The guy borrowed money from his relatives and ended up with about dozen of rare/luxury/sports cars for pennies at a dollar.

The theory doesn't "break" - it describes trends and effects which tend to occur. Examples like yours are not the norm, and the theory allows for instances where buyers have legitimate reasons for quickly offloading valuable goods.

This is not the theory breaking. In your example, the information asymmetry is other way around. 1) The buyer knows more about the true value of the cars compared to the seller. and/or 2) the seller doesn't care.

The theory predicts that peaches will have to be sold for less than they're worth if they have to be sold, so this fits the theory.

> [...] Then they are only willing to pay a fixed price for a car that averages the value of a "peach" and "lemon" together (p_avg).

So every used car has the same price?

No, because there are other factors than whether they are a ‘lemon’ or a ‘peach’. For example, age, mileage, brand value, warranty offered, convenience of purchase, etc. These don’t tell you whether the car is a lemon or a peach, although some can help you to guess it.

If you held all these other factors constant, then yes, all used cars would have the same price.

That’s what the Kelly Blue Book thinks

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