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Why does a car lose 18% of its value immediately after you buy it from the dealer?
#Econgram_economic_concepts
One of the most famous economic papers is “Market for Lemons” by George Akerlof. The paper investigates a market for used cars where both good-quality (“peaches”) and bad-quality (“lemons”) cars are sold. However, while the sellers know the quality of their autos, the buyers do not.
As buyers are unsure about the car’s quality, they offer a small price. Therefore, owners of good-quality autos cannot get a fair price: they leave the market. As a result, Akerlof predicted that the market should consequently end up consisting of bad cars - lemons.
In 2019, a group of scientists* investigated empirical evidence consistent with the Market for Lemons theory in the Danish car market. They discovered that good-quality cars sold in the first year of ownership were priced 18% below their value. However, the so-called “lemon penalty” decreased over time: in the second year of ownership it was 8% and by the 9th year it vanished.
The market for lemons is an example of adverse selection - a situation in which buyers and sellers have different information about the good. Adverse selection often leads to a market failure, a situation in which the rational* behaviour of all market participants leads to an inefficient* distribution of resources.
To overcome the Lemons’ problem, Akerlof proposes the sellers issue warranties against future malfunctioning of their cars. Sellers of peaches would be more willing to issue warranties than sellers of lemons. Therefore, it would be easier for the buyers to distinguish between lemons and peaches.
Inspired by The Economist
Do you know other real-life examples of adverse selection? Share them in the comments!
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