Solving the lemons problem

As geekier types will know, there shouldn\’t actually be a market for second hand cars. The asymmetry of information is just too large.

The seller knows whether he\’s got a complete dog or not (one of those fridday afternoon Jaguars for example) and the buyer doesn\’t. So the buyer should be pricing all cars as if they\’re a friday afternoon dog and sellers will therefore only be willing to sell such dogs. The decent cars simply never appear on the market.

That\’s the beginning of the story which led to a Nobel and the wrinkle is that of course we do in fact see a market for used cars and one that works reasonably well. That information asymmetry does mean that it works less well than one without such problems, this is true, but the reason for that is that the market itself has worked to overcome some (if not all) of these problems. RAC inspections, checks on the title chain, even, and no, don\’t laugh, the reputation or not of the garage selling the dodgy motors.

There is some amusement that it\’s the very functioning of this market, despite the fact that theory says it probably shouldn\’t, which pays for all those writers at The Guardian who insist that markets don\’t/shouldn\’t work, via Autotrader.

And in further market based attempts tpo solve it we now have Tesco:

In launching the service, Tesco hopes to grab a slice of the £24bn motor market. “It is about following the customer into areas of spend. It is a £24bn market and we will have a tiny proportion of it. We can bring trust. A lot of people find it intimidating with the hard sell. There is no hard sell here,” said Mr Higginson.

All vehicles sold on the site will have undergone independent inspections by the RAC and by HPI Check, a company that investigates vehicles’ ownership histories. The service has been launched following Tesco’s acquisition of a significant minority stake in Carsite, an online dealership. Tesco has an option to take full control of the venture over time.

Shoppers – who can gain up to 2,000 Tesco Clubcard points by buying a car – will be able to search through up to 3,000 former hire or lease cars each week on the website.

Fun how problems with markets in theory seems to get solved by new competition coming in trying to make a profit out of solving that problem. You know, by markets.

21 thoughts on “Solving the lemons problem”

  1. Your initial analysis is incorrect anyway. People don’t just buy cars and run them til they are about to blow up. They buy and sell them for all sorts of reasons. I recently sold my Honda Accord because I have a dog now and needed a hatchback. I bought the Accord from a man whose wife was expecting and he had to sell one of his cars to make ends meet. There was nothing wrong with it mechanically at the time of either sale.

  2. Jim,

    The sour lemons theory in fact says that there will be both good cars (e.g. your Accord) and bad cars (“sour lemons”) on sale. Your example is therefore not at all incompatible with anything Tim has said…

  3. @Emil: what, and no-one can work out whether a car is a dog or not then? Everyone should assume that every car is bad therefore price it accordingly?

    Most sellers have as little knowledge of the true mechanical state of their car as the buyer does. It will be running at the time of sale obviously so unless you have extreme experience of car repairs and can predict when a certain component will fail, you don’t know. You could sell your car, having had a few repair bills, thinking this is on its way out, and it could last someone else years.

    To state that ‘the market in second hand cars shouldn’t exist’ is nonsense. Like all markets it exists because there are differing needs and levels of knowledge. If you know what you’re doing you buy secondhand cars from private sellers, using your experience to pick the good ones. If you know nothing beyond ‘does it go’ then you buy from a garage offering a warranty, and pay the extra for that peace of mind.

  4. Oh, and Tim does say that according to the theory the good cars never appear on the market. They do (as I can attest ) so they theory is cr*p.

  5. Jim:

    “Everyone should assume that every car is bad therefore price it accordingly?”

    This is the sour lemons theory, which is (as most economic theory) developed under a ceteris paribus assumption. As Tim points out it has won the Nobel price (or rather the price to his honour) so you will find plenty of litterature on it…

    BTW: the guarantee you are talking about is one of those innovations mentioned by Tim that make this market work (i.e. a main point of his post) so it’s a poor example to use to try to refute the theory.

  6. Perhaps someone should tell Tesco that the average dealer gross margin is ten per cent and the net margin a lot less than three per cent with a small but significant number of dealers making losses. Turnover isn’t everything!

  7. do Cargiant make a lot of money? They seem to have transformed the market by bringing brand-awareness in, as Tesco are attempting to do.

  8. In the last year for which accounts are available – ending Dec 2009 – Car Giant sold 38,176 cars, turned over £274 million and made £5.5 million net profit. And they’re one of the best and probably the biggest independent.

  9. Well if you can win a Nobel prize for making ludicrous assumptions (‘lets assume people act in a manner totally unlike reality, and conclude that they shouldn’t be acting in the way they do’) it just goes to show there’s plenty of ‘clever’ idiots out there.

  10. “if you can win a Nobel prize…”: well of course he/they didn’t – it was the Swedish Central Bank Prize wot Purports to be a Nobel Prize. Nothing to do with the old boy’s will – just an attempt to piggyback on the reputation of the Physics, Chemistry and Medicine/Physiology prizes. Slightly reminiscent of the market for lemons?

  11. “Well if you can win a Nobel prize for making ludicrous assumptions (‘lets assume people act in a manner totally unlike reality, and conclude that they shouldn’t be acting in the way they do’) it just goes to show there’s plenty of ‘clever’ idiots out there.”

    Actually, that’s how most scientific theories are developed in economy and elsewhere. You build models fixing a set of assumptions in order to be able to abstract.
    The trick for robust research is to then test in reality. You can e.g. think of Marxism or Keynesianism which both were very nice theories that proved not to work in the real world (Marxism because people like to own stuff and need incentives and Keynesianism because politicians are completetly incapable of cutting their spending when times are good)

    In this case, the theory says that if information assymmetry can be reduced then the market will function better. Which is, as Tim pointed out, exactly what has happened in the used cars market through the introduction of guarantees, independent tests, etc. (Remember that the theory was published in 1970 and not yesterday)

  12. @Emil: your lemon theory says that there shouldn’t be a market in used cars. Let’s test that robustly using reality – is there a market in used cars? Why, yes there is, a very large one.

    So your lemon theory is just that – a lemon.

  13. Chris (#6) said “Perhaps someone should tell Tesco that the average dealer gross margin is ten per cent and the net margin a lot less than three per cent ”

    Well, we’ll see how much people value reputation. If Tesco can charge an extra 10% because of a reputation for reliability, then they’ll do well.

  14. “So your lemon theory is just that – a lemon”

    Well, it’s not my theory but Gustaf Akerlof’s… And it is only in its extreme case that it says that there should not be a market in used cars and only under certain conditions, that we have just shown are less and less valid in today’s car market. So I think you’ve been building a bit of a straw man here.

    The point about this theory is however that it has provided some insight re. information assymetry so I wouldn’t say that it is worthless just that the extreme interpretation of it is not very relevant

  15. ok Jim..it was a simple question. How much do you offer me for my wallet? It’s the same problem – Tim expressed it badly – there are good 2nd-hand cars and there are lemons. How does a buyer select? How much do you bid for my wallet? If your bid is less than the contents, then I will not accept your offer. Conversely, then you are left with a sour lemon.

  16. The term “lemon,” as far back as I can remember (which, pertaining to automobiles, is into the late ’40s) was rarely used to describe something bought on the used-car market. It was almost always used in reference to a new car (or, occasionally, to a used car sold by a dealer) with persistent problems. Occasionally, an entire year-model came to be considered a lemon.

    The difference–the quality that characterizes a lemon–is in the reasonable expectation of the buyer for a certain level of trouble-free performance. He counts, in the case of the new car, on its “newness” and, in the case of the used car bought from a dealer, for a certain level of integrity (of the dealer in the representations/ guarantees).

    In general, the law recognizes that a regular dealer in a type of merchandise has an advantage on the buyer consisting in that expertise and, further, that withholding of information (as to condition, for instance) in order to make the sale or obtain a price higher than consistent with that information constitutes fraudulent behavior and is, therefore,
    actionable (at least civilly). No such expertise is assumed of a private seller, though a prospective buyer who is misinformed by a seller (and is able to prove that he was so misinformed, including that the seller knew otherwise) has good prospect of at least partial recovery in civil action.

    Nowadays, there are a number of reliable firms who will perform a battery of tests on a used car (for buyer or seller). Not buying a headache, then, has an approximate price (that of the test).

  17. Diogenes:

    Am I understanding your wallet analogy correctly?
    That, if the buyer pays what the seller asks, he’s getting “took?” That any difference between sellers’ and buyers valuations implies ignorance of some “objective” valuation?

  18. Its simply not true that the buyer has no knowledge of the car on offer, consider the following simple tests
    1, does it look good – rust, body damage etc?
    2, does it start on the button?
    3, is the exhaust clean immediately, after a few minutes?
    4, does it then tick over smooth and quiet?
    5, does it seem to drive properly?
    6, does it go in a straight line if you take your hands off the wheel?
    7, does it stay in a straight line when you brake?

    If all of the above, then she’s probably a “clean runner”. Indeed if the seller is mechanically inept/uninterested you possibly now know more about their car than they do.

  19. johnny bonk:

    It seems (though I don’t know) that you’re criticizing my (above) description. I’d just point out that I in no way imply any particular state or quality of knowledge on the part of either buyer or seller (and they’re not assumed for either legally) except for one “in the business.” Private buyers and sellers can (and do) display every level of both knowledge and ignorance.

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