George Akerlof and the Lemon Problem

lemons_rob-daniGeorge Akerlof put math behind the concept of the  “lemon problem” in his classic 1970 article,

Akerlof (with Michael Spence and Joseph Stiglitz) received the 2001 Nobel Prize for their analyses of markets with asymmetric information.

This YouTube video explains the lemon problem in an easy to understand two-minute clip. In a nutshell, there are honest sellers and dishonest sellers (e.g. those selling lemons). The problem is a buyer can’t easily tell the difference because they don’t have all the information they need and are not as expert as the suppliers at knowing what “good” is. So buyers tend to think the good sellers are overpriced. This leads to a virtual death spiral and chase to the bottom, leading to lower and lower quality over time as the best suppliers are run out of business (or reduce their quality to compete).

I refer to this as over-commoditization and it can also lead to a death spiral where the good supplier either goes out of business or stops adding value and innovating.

So, what does the lemon problem have to do with buying complex services versus used cars?  Perhaps the simplest answer is trust (or lack of it). Akerlof observes, “The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”

If you wonder why your supplier is not innovating perhaps it is because they are in a race to the bottom of the market because the best suppliers can no longer afford to innovate. So you are dealing with lemons, not making lemonade.

Image: Lemons by Rob & Dani via Flickr CC

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