The Lemon Principle and Market Failure In The Used Car Industry cars


Imagine if you are shopping for a used car, and suddenly someone came to you on the street and claims a bold demand: "The used car market has only low-priced cars for sale!" Would you agree with this statement?

Well, there are reasons to believe that this statement has got a truth ring after all!

According to the seminar title The market for lemons: Quality Uncertainty and 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, can actually be mathematically proven. In this document he won even the Nobel Prize in 2001!

In this document, George used the term lemons to designate used cars of poor quality (Lemon is actually an American snake used to represent a bad car) and the term peaches to designate used cards of good quality. Sellers who sell used cars to the used car market fully know the quality of the car he sells; sellers know if he sells one Lemon or a Peach to the used car market because he has driven his car before.

Unfortunately, buyers of these used cars cannot control the exact quality of the cars. Knowledge of the quality of these used cars is not as complete as the sellers. In other words, there is an asymmetric information between buyers and sellers. The sellers know more about the quality of their car than the buyers.

This difference in knowledge and information with regard to the quality of the cars has major consequences as regards the pricing of the cars and what type of cars are traded. Sellers who know their car is one Peach will want to sell their cars at higher prices, while sellers who know fully that their car is one Lemon Will be willing to accept a lower price to sell off their low quality used car.

However, since the buyer cannot determine the quality of the car, he will not be willing to pay the full price sold by the seller selling Peach, and will stop paying anywhere lower than the reasonable price yet Peach commands.

Let me illustrate this buyer-seller dynamics with a brief example.

Imagine if you are a buyer of a used car. You met Patrick who wants to sell you his Peach. Since Patrick knows he is selling a peach, he will demand a high price (let's say $ 20,000) to sell his car. But because you, the buyer, can't check if this car is one PeachSo, you're not willing to take the risk of paying him the $ 20,000 high price to buy the car. You will tell Patrick that because there is a chance you might end up on one Lemon, you're just willing to pay a lower $ 15,000 fee for the car.

As a result, Patrick will not be willing to accept your $ 15,000 offer Peach he has, and the transaction is unlikely to go through.

But if Patrick knows he's selling one Lemon, he will be willing to share his car for $ 10,000. In this case, because you are offering $ 15,000, Patrick will be happy to sell your car and the deal will be completed.

Note that I have simplified this example to just show the dynamics of the buyer's seller. $ 15,000 is the average price buyer in the used car market will stop paying, and is calculated based on the expected value of a car pool, provided that 50% of the cars sold are peaches and 50% of the cars sold are lemons, and that after having a total of all prices on peaches and lemons, the average price of peaches is $ 20,000, and the average price of lemons is $ 10,000. This simplified example can be proven mathematically.

Thus, the used car industry has failed because no owner of peaches will want to sell their high quality cars if they know that they receive on average a fee that is lower than their peaches justify. But the owner of lemons will be happy to sell their cars because they on average receive a higher fee than their low-quality cars can order. The lemons has effectively penetrated peaches, the average quality of cars sold has declined lemons, and there has been a market failure 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 Cars For Sale!" On average, and in general, this claim applies, at least based on the written by George Akerlof. George Akerlof described this dynamic lemon principle.