Bryan Caplan  

Economics and Fallibility

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When students first hear about the famous Akerlof's "lemons model," they almost invariably misinterpret it.  "Aha," they think, "this is why used car dealers get rich ripping off unsuspecting customers."  The true point, of course, is that asymmetric information makes customers suspicious, leading to lower demand, prompting reliable sellers to leave the market, which in turn intensifies customer suspicion.

Only recently, though, did I discover an especially excellent textbook discussion of this point.  From McCloskey's The Applied Theory of Price (available free of charge in its entirety on the author's website!):
If people are aware of their own ignorance - the first stage of true wisdom - then they will not buy any secondhand car, knowing that it must be a lemon.  The exchange will simply not happen, one way of avoiding a bad exchange.  Or dealers who can determine whether a car is a lemon will spring up, guaranteeing the car (at a price).  Or knowledge that one is buying a lemon if one buys from Sam's Fly-by-Night Auto Sales will become widespread, and the price of the cars that do not end up on Sam's lot will fall closer to their true value.  Perfect knowledge is not necessary for exchange to be mutually beneficial, only knowledge that one is not perfectly knowledgeable. [emphasis mine]
Critics often claim that economists underestimate human being's cognitive limits.  Reflect, then, on how undemanding McCloskey's final assumption is.  You don't have to be Albert Einstein or John von Neumann to acquire the "knowledge that one is not perfectly knowledgeable."  In fact, the less you resemble Einstein and von Neumann, the more obvious your fallibility ought to be.  Just pay attention to the world for five minutes, and this knowledge is yours.



COMMENTS (12 to date)
david writes:

Sadly, dispensing with the knowledge requirements then makes the aggregate properties of equilibrium outcome potentially dubious. In general it will be sensitive to how one models the imperfection. Permit sufficiently weird fallibility and you can have the customers endlessly sell Dutch books to the dealers.

The true value in Akerlof's lemons is demonstrating non-robustness of the intuition of exchange, where the equilibrium changes from full-trade optima to no-trade under apparently minor alterations. Obviously, second-hand car dealers do successfully exist in real life; the model cannot be true as-is. The lemon model will keep changing as you fling more and more conceits at it. A good pedagogical route here would be discussing the theory of the second best.

As a side remark, that textbook seems to fall directly into the gulf of being too complex for the beginner, yet too simple for the intermediate, who reaches straight for MWG and Kreps. I am not sure there was ever value in trying to avoid calculus, yet still being forced toward invoking the intuition of multidimensional surfaces and burying equations in the exercise sets.

Jim Rose writes:

as I recall, vernon smith found that markets work better on low information environments than in high information environments. most of the point of prices is to economise on information.

Phil writes:

Do you mean that critics often claim that economists *overestimate* humans' cognitive limits?

Michael Hamilton writes:

There's also the empirical evidence that used cars are sold constantly and in every part of the country.

jure writes:

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Hazel Meade writes:

I think you're overlooking a significant facet of the issue.
For any given consumer, automobile purchases are sufficiently RARE that they will not likely ever be a repeat customer at the same dealership. As a result, the dealer has little reason to fear losing future business by selling a lemon.

Brian writes:

Hazel,

Not true at all. I and several of my friends have bought multiple used cars over the years from our preferred dealers. If you get one really good used car from a dealer, you are very likely to go back there for the next. This is especially true if you get some regular servicing done there.

The bigger issue is not the dealerships themselves, but the salesman. Many don't stick around for very long, and therefore don't have much incentive to treat the customer well.

Glen Smith writes:

Brian,

There is some repeat business but the main place a salesperson gets his/her leads is from referrals and having a rep for selling lemons kills the credibility of those referrals. Lemon issues may also cause charge backs that'll put you on draw status.

Mark V Anderson writes:

It is an interesting concept, but not very empirically sound. Over the last few decades I have bought several used cars, and not one has been a lemon. I always bought from individuals because I wanted to avoid the dealer markup. I think a careful consumer can identify almost all defects, and so will only get screwed occasionally by the seriously fraudulent seller.

Of course my own experience is just anecdotal, but the existence of a robust re-sale market gives the lie to the theory of a lemon-filled market. It is fine for an economist to discuss this theory as an economic concept, but then it is incumbent on that same economist to explain why it isn't true in real life for the American used auto market. I think that reason is that information isn't quite so asymmetric as the theory postulates.

Brian writes:

Glen,

I agree that reputation is very important, especially for the dealership. It can also matter for the salesperson if they have staying power and develop a personal clientele. In my experience, however, turnover of car salespeople is extremely high, making the individual reputation far less important, if not irrelevant. But either way, reputation and repeat business are strong enough to nullify Hazel's point.

Nickik writes:

One should not underestimate social relations. Almost everybody has some friend or somebody that knows about cars. This friend is probebly happy to help you buying a car.

The same happens with computers all the time, I am a IT and I help lots of people with computers, on of them is a car fixes cars for living.

Bill Conerly writes:

There's a signalling model at work. A consulting project opened my eyes to car dealers. I got to examine in detail the financials for a chain of dealerships. Their new car departments were break-even, but they made good profit on used cars and service. Other folks in the industry told me that many consumers prefer to buy used cars from a dealer who also sells new cars; the new car dealer is considered more reliable than the used car dealer. So the new car department signals to the consumer that this is not a fly-by-night operation (and new car sales feed the service department).

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