The Lemon Principle and Market Failure in the Used Car Industry
Posted On April 4, 2021
Imagine if you are shopping for a used car and suddenly someone came up to you on the street and made a bold statement: “The used car market only has low-quality cars for sale!” Would you have agreed with this statement?
Well, there is reason to believe that this statement has a tone of truth after all!
According to the seminar document titled The market for lemons: uncertainty about quality and the market mechanism written in 1970 by George Akerlof, professor of economics at the University of California at Berkeley, the market failure in the used car industry and thus the claim that only “ bad ” cars can exist in the used car industry, it can actually be shown mathematically. This article even earned him the Nobel Prize in 2001!
In this article, George used the term Lemons to denote poor quality used carslemon is actually American slang used to represent a bad car), and the term Peaches to indicate good quality used cards. Sellers who sold used cars to the used car market know very well the quality of the car they are selling; sellers know if you are selling a lemon or a peach to the used car market because you have driven your car before.
Unfortunately, buyers of these used cars cannot determine the exact quality of the cars; his knowledge of the quality of these used cars is not as complete as that of the salespeople. In other words, there is asymmetric information between buyers and sellers; Sellers know more about the quality of their car than buyers.
This difference in knowledge and information regarding the quality of the cars has huge implications regarding the price of the cars and what kinds of cars are being traded. Sellers who know very well that their car is a peach will want to sell their cars for higher prices, while sellers who know very well that their car is a lemon they will be willing to accept a lower price to sell your poor quality used car.
But because the buyer cannot determine the quality of the car, he will not be willing to pay the full price ordered by the seller selling the car. peach, and you will end up paying somewhere lower than the reasonable price than the peach commands.
Let me illustrate this dynamic buyer-seller with a brief example.
Imagine if you are a used car buyer. You met Patrick who wants to sell you his peach. Since Patrick knows that he is selling a peach, he will demand a high price (say $ 20,000) to sell his car. But because you, the buyer, cannot determine if this car is a peachTherefore, he is not willing to risk paying you the high price of $ 20,000 to buy the car. You will tell Patrick that since there is a chance that you will end up buying a lemon, you’re only willing to pay a lower $ 15,000 fee for the car.
As a result, Patrick will not be willing to accept your offer of $ 15,000 for the peach it has, and the transaction is unlikely to go through.
But if Patrick knows he’s selling a lemon, you will be willing to ditch your car for $ 10,000. In this case, because you are offering $ 15,000, Patrick will be happy to sell you his car and the deal will close.
Note that I have simplified this example to show only the essence of the buyer-seller dynamic. $ 15,000 is the average price that buyers in the used car market will end up paying, and is calculated based on the expected value of a group of cars, assuming that 50% of the cars sold are Peaches and 50% of the cars sold are Lemons, and that after adding all the prices of the Peaches and Lemons, the average price of Peaches is $ 20,000, and the average price of the Lemons is $ 10,000. This simplified example can be demonstrated mathematically.
Therefore, the used car industry has failed because no owner of Peaches they will want to sell their high-quality cars if they know that, on average, they will receive a lower rate than they pay Peaches justify. Purpose owners of Lemons they will gladly sell their cars because on average, they will receive a higher rate than their low quality cars can demand. Tea Lemons have effectively displaced Peaches, the average quality of the cars sold has dropped to that of Lemons, and that there has been a market failure in the used car market.
Going back to the statement presented to you in the introduction to this article, “The used car market only has low quality cars for sale!” On average, and overall, this statement is true, at least according to the article written by George Akerlof. George Akerlof called this dynamic The lemon principle.