Asymmetric Information and Used Cars

Asymmetric Information and Used Cars


♪ [music] ♪ – [Narrator] The famous comedian
Groucho Marx once said, – [Groucho] “I don’t want
to belong to any club that would accept me as a member.” – [Narrator] Believe it or not,
the economist George Akerlof won a Nobel Prize for analyzing when Groucho-type
reasoning makes sense and what the consequences are. Groucho was using the fact that the club was offering
him membership to infer something about
the quality of the club. – “Yeah, because it’s
not very exclusive.” – Akerlof analyzed
the more general situation of adverse selection when an offer conveys
negative information about what is being offered. Akerlof’s famous example
was the market for used cars. Suppose that used cars
come in a variety of qualities.>From the worst — the lemons, the cars that always
are breaking down, to the very best,
the most reliable cars — the plums. The sellers know
the quality of their car, but suppose
that the buyers can’t tell which used cars are lemons
and which are plums. Since the sellers have
more information than the buyers, this is a model
of asymmetric information. Since the buyers
can’t tell the difference between a lemon and a plum, they won’t be willing to pay more than what an average
quality car is worth. But seeing that the buyers
are only willing to pay for average quality, sellers of the highest quality cars — the plums — will exit the market. When the highest quality cars
exit the market, however, the average quality of car falls, which reduces the price the buyers
are willing to pay even more. And that causes the sellers of the next
highest quality used cars to drop out of the market as well. At the end of what is sometimes
is called “the death spiral,” the market collapses
and buyers conclude, just like Groucho, that they wouldn’t want to buy any car
that is offered for sale. Of course, in the real world
the used car market is thriving. Some 40 million used cars
are sold every year — more than three times
the number of new cars. That doesn’t mean
the model is wrong. It means that over time
the market has developed solutions to the asymmetric
information problem. Solutions like inspections,
CARFAX reports, and certified pre-owned programs that offer buyers
guarantees of quality. The Adverse Selection model
also has implications far beyond the used car market, most importantly
to understanding debates over health insurance, as we discuss in future videos. – [Narrator] If you want
to test yourself, click “Practice Questions.” Or if you’re ready to move on,
just click “Next Video.” ♪ [music] ♪

About the Author: Michael Flood

9 Comments

  1. I liked this video a lot and I linked it to a post I wrote where the lemon problem applies to crowdfunding:
    https://www.reddit.com/r/ethereum/comments/5vyc6d/peerback_white_paper_the_market_for_lemons_are/

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