Peaches and Lemons

Akerlof, Stiglitz and Spence jointly won a Nobel Prize in 2001 for their insights on asymmetric information.  They used the market for second-hand cars to illustrate the problem of when a buyer knows more than a seller: quality uncertainty.

There are two types of second-hand cars; the good, functioning cars (peaches) and the bad, defect-ridden cars (lemons).  However, the market for peaches and lemons are not separate.  Consumers cannot distinguish between the two for many reasons - they cannot access all the hidden mechanical parts, they are not car experts or they do not know the history of the vehicle.  Thus, they will only find out whether it is a peach or lemon after the purchase - which of course, is too late.

Therefore, the buyer’s best guess is the average quality.  The owner is only willing to pay what the average known quality of the car is.  This leads to a market failure - an information asymmetry has led to adverse selection.  The peaches, as a reaction to the lower price, will be unwilling or forced to leave the market.  Once the peaches start to withdraw, the proportion of lemons increase.  Thus, the likelihood of a consumer buying a lemon increases - yes, adverse selection in all its glory.

The problem here is that sellers, especially lemons, have a financial incentive to pass of their cars as “good”.  This introduces an element of risk for the consumer who risks overpaying at an unfair price for a lemon.  To coin the economic principle of Gresham’s Law, the bad cars drive the good cars out of the market - literally.

To overcome this problem, the information gap needs to be reduced.  To compensate for the lack of expertise, on the consumer’s behalf, an independent third party can be introduced to reveal the quality of the car.  Peaches can be given rubberstamp to indicate that they have been inspected and are road-worthy.
It may be impractical for every car dealer to attain this certified status in terms of the efficiency of the market.  In this case, both parties can agree a warranty - an assurance by the car dealer to the consumer that the car is functioning.  If this proves to be untrue, the consumer may seek compensation.

In the age of technology, the wonders of the internet can be harnessed.  Consumers can review their second-hand cars and car dealers to inform potential future consumers.  Thus, car dealers have an incentive to maintain their reputation - something which lemons cannot rely on.  This will solve the problem of adverse selection.  Nevertheless, this is practically tricky.  The nature of dodgy car dealers, the lemons, are that they are small dealers and elusive.  They only sell a few cars and keep moving location.  As a result of this and the fact that they are unofficial renders this internet based solution largely ineffective against this particular type of car dealer.