The Lemon Principle and Market Failure In The Used Car Industry
Imagine if you are shopping for a used car, and suddenly, someone came up to you on the street and assert a bold claim, "The used car market has only low quality cars for sale!" Would you have agreed with this statement?
Well, there are reasons to believe that this statement has got a ring of truth after all!
According to the seminar paper titled The Market For Lemons: Quality Uncertainty and The Market Mechanism written in 1970 by George Akerlof, Professor for Economics at the University of California at Berkeley, the market failure in the used car industry and hence, the assertion that only 'bad' cars can exist in the used car industry, can actually be mathematically proven. This paper even won him the Nobel Prize in 2001!
In this paper, George used the term Lemons to denote used cars of poor quality (Lemon is actually an American slang used to represent a bad car), and the term Peaches to denote used cards of good quality. Sellers who sold used cars to the used car market knows full well the quality of the car he is selling; sellers know whether he is selling a Lemon or a Peach to the used car market because he has driven his car before.
Unfortunately, buyers of these used cars are unable to ascertain the exactly quality of the cars; their knowledge of the quality of these used cars are not as complete as that of the sellers. In other words, there exist an asymmetric information between the buyers and the sellers; the sellers know more about the quality of their car than the buyers.
This difference in knowledge and information with regards to the quality of the cars has huge implications with regards to the pricing of the cars and what kind of cars get transacted. Sellers who know full well that their car is a Peach will want to sell their cars at higher prices, while sellers who know full well that their car is a Lemon will be willing to accept a lower price to sell off their low-quality used car.
But because the buyer is unable to ascertain the quality of the car, he will thus be unwilling to pay the full price commanded by the seller who is selling the Peach, and will end up paying somewhere lower than the reasonable price than the Peach commands.
Let me illustrate this buyer-seller dynamic using a short example.
Imagine if you are a buyer of a used car. You met Patrick who wants to sell you his Peach. Because Patrick knows that he is selling a Peach, he will demand a high price (let's say $20,000) to sell off his car. But because you, the buyer, is unable to ascertain whether this car is a Peach, you are thus not willing to take the risk of paying him the high price of $20,000 to buy the car. You will tell Patrick that since there is a chance you might end up buying a Lemon, you are only willing to pay a lower fee of $15,000 for the car.
As a result, Patrick will not be willing to accept your $15,000 offer for the Peach he has, and the transaction is unlikely to go through.
But if Patrick knows that he is selling a Lemon, he will be willing to part with his car for $10,000. In this case because you offer $15,000, Patrick will gladly sell you his car and the deal gets concluded.
Note that I have simplified this example to show only the gist of the buyer-seller dynamic. $15,000 is the average price buyers in the used car market will end up paying, and is calculated based on the expected value of a pool of cars, assuming that 50% of the cars sold are Peaches and 50% of the cars sold are Lemons, and that after aggregating all the prices of the Peaches and Lemons, the mean price of the Peaches is $20,000, and the mean price of the Lemons is $10,000. This simplified example can be mathematically proven.
Thus, the used car industry has failed because no owners of Peaches will want to sell their high quality cars if they know that on average, they will receive a fee that is lower than what their Peaches justify. But owners of Lemons will gladly sell their cars because on average, they will receive a higher fee than what their low quality cars can command. The Lemons have effectively crowded out the Peaches, the average quality of cars sold has declined to that of Lemons, and that market failure has occurred in the used car market.
Back to the statement presented to you in the introduction of this article, "The used car market has only low quality cars for sale!" On average, and in general, this statement holds true, at least based on the paper written by George Akerlof. George Akerlof termed this dynamic The Lemon Principle.