KEY POINTS:
In his book The Undercover Economist, Tim Harford tells why it's almost impossible to buy a good used car.
Economists have known for a while that if one party to a deal has inside information and the other does not, then markets may not work as well as we would hope. That makes intuitive sense. But it wasn't until an American economist named George Akerlof published a revolutionary paper in 1970 that the profession realised quite how profound and dramatic the problem might be.
Akerlof chose as his example the market for used cars and showed that even if the market is highly competitive, it cannot work if sellers know a lot about the quality of their cars and buyers do not.
Let's say that half the used cars on sale are "peaches" and half are "lemons". The peaches are worth more to prospective buyers than to sellers - otherwise the buyers wouldn't be buyers - say, £5000 to prospective buyers and £4000 to sellers. The lemons are worthless pieces of junk. Sellers know whether the car they're selling is a lemon or a peach. Buyers have to guess.
A buyer who doesn't mind taking a fair gamble might think that anything between £2000 and £2500 would be a reasonable price for a car that has a 50 per cent chance of being a peach, and a 50 per cent chance of being a lemon.
The seller would also think this was a fair deal for a 50/50 prospect, but the seller doesn't face a 50/50 prospect: The seller knows for certain whether the car is a peach or a lemon.
Wandering around offering £2500 for a car, you quickly discover that only lemons are for sale at that price. Of course, if you offered £4001 you would also see the peaches on the market - but the lemons won't go away, and £4001 is not an attractive price for a car that has only a 50 per cent chance of running properly.
This isn't just a trivial problem around the fringes of the market. In this scenario, there is no market. No seller is willing to sell a peach for less than £4000, but no buyer is willing to offer that much on a car that has a 50 per cent chance of being a lemon. Sellers don't offer peaches for sale, buyers know that they won't and in the end the only cars that are traded are worthless lemons, which get passed around for next to nothing.
Less extreme assumptions about the problem lead to less extreme breakdowns of the market, but the conclusions are similar - if some people know more than others about the quality of a product, then some high-quality products may not be traded at all, or not be traded very much.
Anyone who has ever tried to buy a second-hand car will appreciate that Akerlof was on to something. The market doesn't work nearly as well as it should; second-hand cars tend to be cheap and of poor quality. Sellers with good cars want to hold out for a good price, but because they cannot prove that a good car really is a peach, they cannot get that price and prefer to keep the car for themselves. You might expect that the sellers would benefit from their inside information, but there are no winners: Smart buyers don't show up to play a rigged game.
What Akerlof described is not a market where some people get ripped off; it's much more serious than that. He described a market that should exist and doesn't because of the corrosive force of inside information. Sellers with good cars should be trading with buyers - each trade produces £1000 of value, because that's the difference between the value to the seller and the value to the buyer. If the price is close to £4000, the buyer gets more of that value, and if it is close to £5000, the seller gets more. But Akerlof showed that none of those value-creating trades happen because the buyers will not buy without proof, and the sellers cannot offer proof.
Inside information also makes it hard to get a decent meal in a tourist trap like London's Leicester Square or Times Square in Manhattan. The hungry visitor will almost always pay a lot for mediocre cuisine.
Tourists are willing to pay high prices because they have no sense of where better alternatives, even just a few streets away, might be found. But the tourist-trap phenomenon is not just about high prices. If it was, we would see a wide range of restaurants, charming little bistros and down-market pasta or burger joints, all kinds of food from superb to disastrous, all charging a premium.
Instead, we see a truncated market - high-quality places, whether the good food is fried chicken or fine dining, are not to be found. I think the reason is simple enough; tourists will be making only a single visit and will find it hard to pick out the great food from the bad. Good restaurants all locate where they are more likely to be appreciated by more informed locals. The bad ones remain ... the "lemons" of the restaurant trade.
It's worth emphasising that Akerlof is not describing universal ignorance but a situation where one side knows more than the other. It's only when one negotiator knows too much and the other too little that agreement is impossible. This information imbalance can destroy perfect markets.
