In 1970, a behavioural economist by the name of George Akerlof published a paper titled The Market for Lemons: Quality Uncertainty and the Market Mechanism. The paper discussed the problem that arises when a buyer and a seller of a product have asymmetric (lopsided) information about its true value. It was called the 'lemons problem' because 'lemon' was a popular term used to describe a defective car.
The Lemons Problem exists in many markets, but it was popularized by the used car market. If I continue to illustrate the Lemons Problem with the used car market, I would summarize the problem thusly: car sellers (typically) know more than car buyers.
So, how can a buyer trust that a used car is any good?
The Uninformed Consumer
Akerlof hypothesized that a consumer with disadvantaged asymmetric information to the seller will offer no more than the median price between a good used car and a used car in need of repair. As an example, if a good car is worth $20,000 and the very same "as-is" car is worth $10,000, the consumer will offer $15,000 as a way of hedging their bet.
The problem here is that no good dealer will sell a decent car for less than its value. Only the cheaters will take this deal (and pocket a tidy $5,000 for each lemon they sell). If this were to continue, the entire used car market would become cheaters as all of the good dealers with good cars will go out of business.
There are honest dealers and cheats, and it’s hard to know the difference — that is unless you take the time to become an informed consumer.
The Informed Consumer
Ther are a few things honest dealers and consumers can do to balance the scales.
One of the most common ways for honest dealers to entice consumers is with a trusted certification. When it comes to used cars, the automakers and dealers create standardized audits. You will perhaps have heard of "GM Certified" or "BMW Pre-Owned" programs, which are intended to give buyers more confidence when they set out to purchase a used car.
Certifications exist in many markets.
Honest dealers will also offer competitive warranties with the vehicles they sell. A warranty suggests to you, the buyer, that your vehicle is in good condition, otherwise it will have to be repaired at the expense of the seller. An informed consumer will not only compare vehicles, but compare data such as terms of warranties and vehicle history.
Ask for information you can't find online.
A common trick to defeat the lemons problem are external experts. In real estate, you often rely upon advice from experts to help you navigate the housing market. In the real estate market, the seller might know there's something wrong with his house, but he still wants the highest selling price. If you're the buyer, you can enlist third-parties to help you to determine a fair price. Real estate agents, appraisers, building inspectors, and public records can all help you negotiate the right price.
In the used car market, you can ask a trusted mechanic to look over the car before you buy. Experts aren’t always right, but a second pair of eyes is always a good idea.
Information asymmetry can impose a huge cost on the person with less information. The best way to equip yourself in the fight against information asymmetry is to gather as much information as possible about your prospective purchase prior to negotiating the transaction. It’s harder to get ripped off when you do your homework!
Not All Cars are Made Equal
In keeping with the used car theme, it's important to remember that not all cars are made equal. An identical make, model and year can have differences in build quality. This was especially true in the days before robot welding and laser measured quality control.
Applying this premise to another market, say used electronics, specifically televisions, you shouldn't simply trust that Craigslist ad for a 2015 Brand Name TV because online reviews for the 2015 Brand Name TV were overwhelmingly positive. Make the sale contingent on you watching a few minutes of television at their place before handing over the cash. Allow yourself an opportunity to back out of the transaction if it doesn't resemble the "factory condition" advertised.
Show Your Cards
If you try to sell a brand new car after only a few months, you'll become victim to the lemons problem. No one will believe you that your car is good — they'll assume it's a lemon because of how quickly you're selling it, and you'll only get lemon-like offers. In many cases, you can lose up to 20% of the value of the car when you drive it off the dealer's lot! This extreme loss in value largely boils down to information asymmetry.
If you ever find yourself the seller, find a way to put the buyer's mind at ease by purchasing a vehicle history report from a company like CarFax. If you're selling your home, hire your own inspector to deliver to you a pre-emptive inspection report, which you can share with prospective buyers. Showing your cards typically gets you a better price.