Why My Customers Look So Suspicious?

“The Market for Lemons: Quality Uncertainty and the Market Mechanism” is a well-known 1970 paper written by George Akerlof, an economist, and a professor at the University of California, Berkeley.
The paper portrays how the information asymmetry between buyers and sellers can cause the market to collapse.

Gresham’s Law states that- “Bad money drives out good”. This is what happens in our market for lemons and cherries. Through the given model we have explained how information asymmetry between a buyer and a seller can lead to systemic risk in an economy and cause a market collapse. Adverse selection and moral hazard (explained with the help of the insurance sector) are the most common problems which need to be addressed while bridging the information gap.

We are presented with someone who wants to buy a car and decides to scout the second-hand car market for a bargain. The market comprises of two types of cars-
• Defective and worn-out cars or “lemons”
• High-quality premium cars or “cherries”

The buyers, oblivious to the proportion of the same, choose to pay an amount which equals the average of the quality of both the cars. Hence, the sellers holding ‘cherries’ will leave the market further increasing the proportion of ‘lemons’. This will create a cyclical feedback loop amplifying the lemon sellers’ exit from the market.

The lemon problem prevalent behind various financial depressions:
Information asymmetry was the reason behind the bust of several macroeconomic bubbles like the dot-com bubble in the early ’20s and the famous housing market collapse triggering the 2008 Global Financial Crisis (GFC). It was this asymmetry between the banking sector, the real estate market (in case of GFC), the IT sector and the market in general (in case of Dot-Com mania) which wiped off trillions of dollars across the globe.

The Dot-Com Mania:

The Dot-Com mania was severe but short-lived (ranging from September 1998 till March 2000). It marked the advent of a Silicon Valley gold rush: there was money everywhere. Tech billionaires tried to pay their thousand-dollar dinner bills with the shares of their startup-sometimes it even worked. Every month, dozens of startups competed to host the most lavish launch party. Everyone should have anticipated that the boom was unsustainable. In December ’96-more than three years before the bubble burst-Fed chairman Alan Greenspan warned that “irrational exuberance” might have “unduly escalated asset values”. But it’s hard to criticize people for dancing when the music was playing; irrationality was rational given that adding “.com” to your name could double your value overnight.

The 2007-09 Global Financial Crisis:

In the early 2000s, widespread credit exposure taken by the investment banks was based on the ‘assumption’ that the real estate market is ‘bound to rise’. The lemon problem which demonstrates the adverse selection mechanism clearly explains how these bankers used financial engineering to design complex derivative products to securitize their assets (which soon turned into NPAs). New structured products like the Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs) rose to prominence providing immense leverage and encouraging more speculation (in addition to the rapid growth in the CDO market the CDS market grew from $8 trillion to $60 trillion during 2004 to 2007-time period).

Rating Agencies doing the spill-over:

Rating agencies, on the other hand, helped the banks to package these ‘lemons’ and sell them in the market. Out of sheer greed, they over-rated the sub-prime mortgage-backed securities (MBSs) (for instance they rated a BBB security as a AAA) and made them available to the public. These ‘lemons’ soon defaulted which burst the bubble. The system had to breakdown. Stock markets crashed, banks went bankrupt and the real-estate sector lost its value. This was enough to ring the bell that the world was staring at a recession.

In our market for lemons’ and cherries’, as more and more cherry sellers left the market we needed a vehicle (like a ‘rating agency’ which provides “genuine” credit ratings) to facilitate the sale of cherries and revive the otherwise looming lemon market. Alike the credit rating agencies, our vehicle would serve as an intermediate by taking a commission from the buyer and the seller of our market and facilitating “quality” trade.

Insurance sector itself not insured?

The insurance sector is a classic example of information asymmetry from the buyers point of view. Buyers of insurance commit such practices to derive an unwarranted profit out of an otherwise rejected health insurance purchase proposal. In the words of McCloskey: “Which farmer is most eager to buy crop insurance?”. The one who jolly-well knows that his crops are going to fail. Similarly, the person who buys life insurance is usually the one who has a series of prevailing cardiac problems hidden from the insurer. This is sometimes referred to as moral hazard. Thereby the insurance company ends up ensuring those who are at a higher risk of losing their lives leading to adverse selection.

Hence, information asymmetry and moral hazard are interdependent. They are two sides of the same coin. Such asymmetry, in the long run, creates a bubble which can be detrimental to the growth of the economy. It distorts the fair value of an enterprise and the economy in general. The bubble, once burst, triggers a systemic risk which often spreads across the industry. If no such asymmetry exists, and businesses run with utmost transparency and due-diligence, the economy is bound to flourish and grow.