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.

What Is Value?

It’s a slippery issue: what is value? By this I mean, what is the value that a customer is willing to pay for? In my MBA’s marketing class, the term “value” is thrown around an awful lot, but it’s always left in intangible terms. Then again, is there really such a thing as tangible value?

When I go shopping, what are the tangible properties of an item I buy? The physical form of the product itself. Embodied in this physical form are explicit attributes, such as the function the product performs or how well it performs that function. But there are also a number of implicit attributes of the product that I’m also paying for: the “quality” of the product, the prestige of the product, and the convenience of where I bought the item.

The value of some of these explicit and implicit attributes can be measured quantifiably. For example, I can measure the item’s performance and then value that performance based on how much I might save in time or money by buying the item versus not buying it. I might value the item’s “convenience” value by determining the cost to me to buy a comparable item in another location.

But what about prestige? How do I value prestige? Prestige value is related to the way people’s impression of me is altered by me buying the item. But what is the value of other people’s opinion of me? If the item causes me to gain access to a new job, I suppose I could value it in terms of how my income changes. But that’s a tenuous link, one that hardly might only apply to an Armani suit, but not a pair of Converse canvas sneakers. So what’s left?

The issue that prompted this line of consideration was a business case we studied last term. In the case, BC Packers, a local salmon and tuna cannery, was considering entering the canned cat food industry. It had to determine whether to enter the low-priced segment, the national brand segment, or the premium-priced segment. What disturbed me was the fact that we could apply different values to exactly the same product. It didn’t seem reasonable to me that we should be able to, for example, charge twice the price for a premium brand as for a price brand, just because our advertising campaign tickled some endorphins from some single female in her mid-thirties who views her cat as a child substitute. Sure, we have extra costs incurred in the form of advertising, but was it worth that much?

Then I realized that the attributes I had deemed “quantifiable” weren’t quantifiable at all! Sure, they could be quantified in terms of money and time, but how could you value those things? If time is money, then the reverse is true, hence I’ve only quantified tings in terms of time. What is my time but a human perception of its surroundings; and what is my value of prestige but my perception of other’s value of me?

It would seem that “value” is a shorthand for perception and time. Our time is finite and hence so is our opportunity for perception. That leads me to believe that no matter what product we’re purchasing, the finite length of our lives means that we’re ultimately buying more time. Time to live. Time to experience. Time to earn an income. And, of course, time enough to buy more time. Hence, “value” ends up being a balance between our ability to pay and our desire to live our life more fully.

There is no logic to value. We pay what we’re willing and able to pay and no less.