Rafi Mohammed

Want to Learn More About One of the Best Articles in the History of Economics? Read this Blog

Posted on June 12th, 2007 (0 Comments)

As a graduate student, it was engrained into me that George Akerlof’s article “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism” (Quarterly Journal of Economics, 1970) was a seminal economics article. In awarding Akerlof the 2001 Nobel Prize, the Nobel Prize committee declared his “Lemons” paper to be the “single most important study in the literature of the economics of information.” So enthralled with Akerlof’s ideas, a friend of mine even constructed a shrine in his apartment full of posters, gold framed article reprints, and candles. Somehow I had missed reading this article during the 10:30 AM to 2 PM working hours I maintained while in graduate school (…those were the days). So I recently decided to read the Lemons paper to see what the hoopla is all about.

Akerlof focuses on markets characterized by heterogeneous products (not all products are the same) and asymmetric information (some people have more information than others). As an example, he discusses the decision process of buying a used car. Some used cars are good, others are lemons (heterogeneous products) and sellers know if their used car is a lemon or not (asymmetric information). Akerlof assumes the market price for used cars will be low – since lemon owners want to dump their cars and buyers know this. In turn, these low prices make it uneconomical for “good” car owners to put their cars on the market – because market prices reflect the value of lemons. The key insight of the “Lemons” paper is that in this situation, markets collapse or are characterized by adverse selection (only poor products are available). To remedy this market outcome, many luxury automakers now offer "certified" pre-owned cars that sell at prices well above those of regular used cars.

While I found this article interesting, these insights didn’t initially strike me as on par with the typical “curing a terrible disease” or “achieving peace between warring factions” accomplishments recognized by the Nobel committee. My economist friends reminded me that while Akerlof’s insights are obvious today, in 1970 (when the article was published) economists believed that markets worked perfectly. Akerlof’s 13 page article convincingly challenged this convention and entirely changed the way economists looked at markets.

The "Lemons" paper is still relevant today and few appreciate it more than the two Stanford graduate students who started StubHub, a ticket resale service. When you think about it, the sports & concert ticket resale market exhibits Akerlof’s assumptions: heterogenous goods (some good, some counterfeit tickets) and asymmetric information (sellers know if counterfeit, buyers don’t). StubHub offers a marketplace that guarantees tickets. If the tickets are counterfeit or not as promised, StubHub refunds buyers their purchase price. This service provides value for both sellers (who pay a 15% commission for the guarantee benefit) and buyers (who pay a 10% commission for the insurance benefit).

Seven years after its inception, StubHub’s annual revenues are estimated at $400 million with $10 million in net profits. Oh…and eBay recently purchase the company for $310 million. What a homerun idea…I bet StubHub’s investors exuberantly chicken dance in front of their own personal Akerlof shrine daily!

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