Adverse Selection

Economic theory can explain everything, even the mundane. Consider the market for lemon cars and the concept of adverse selection. Economists have developed an entire story to explain why, due to imperfect information, only lemon cars are sold in the used car market. And the story goes a little something like this:

(And a one, and a two, and a…)

Let’s say there’s a used car market consisting solely of two people who want to sell their car. Call these people Alice and Eve. Alice has a great car in perfect condition with low mileage; Eve has a similar car, but she’s had nothing but problems with the vehicle and wants to get rid of it. To a potential buyer, Bob, the cars appear to be equivalent. Alice knows she’s got a good car and therefore expects to sell the car for price P. Eve knows she’s got a lemon and therefore expects to sell the car for price X, where X is less than P. Simple enough, right?

Eve notices that her car appears equivalent to Alice’s car and realizes that she could probably charge more than X. After all, how is Bob to know the difference? So, Eve will try to sell her car at some price greater than X, but less than P. Alice notices that her car appears equivalent to Eve’s car, suggesting that Bob will value her car at the same value as Eve’s car. As a result, Alice chooses not to sell her car in the market because she won’t get the price she wants for the car. This leaves Eve’s car as the only available option in the used car market.

Only lemons? Ouch! Doesn’t sound like the kind of market you want to be buying from!

Consumers can protect themselves by attempting to compensate for this information gap using insurance title searches, consumer reports, or independent certification by a mechanic. But in a market filled with millions of products, not just cars, is this feasible? Consider my experience with my wife’s Sony laptop: great company, good brand reputation, garbage product. Even with the product’s recent bad publicity, how many people are being “taken” by Sony’s inferior laptop products? A heckuva lot, I’m willing to bet.

Bad products are like spam. Most people won’t buy products advertised in spam, but if even one in a million recipients buy the product, the company sending the spam is ahead of the game. Similarly, if just enough people get suckered into buying a crappy product, another company earns a few more bucks it doesn’t really deserve. And you, as the customer in either case, are left with yet another penis enhancer that doesn’t work.

Now if that isn’t a depressing conclusion, I don’t know what is.

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