The Ultimate Lemon

Even when markets fail, market-based solutions can often be better than government ones. This needs emphasis in the wake of the Nobel Prize for economics going to George Akerloff, Joseph Stiglitz and Michael Spence, for showing that lack of formation can cause market aberrations and even collapse.

Akerloff set the ball rolling in 1970 with his theory of lemons. In India, lemons mean a sort of fruit. But Americans use the word lemon to mean a defective item up for sale. A defective car, for instance, is a lemon.

Sellers know what is good or bad about their second-hand cars. But potential buyers lack such knowledge, and suspect the worst. So, they offer low prices, so low that owners of high-quality cars withdraw from the market, leaving only the lemons for sale. This fall in quality can make buyers even more suspicious, drive prices down further, and further reduce the quality of cars offered for sale, in a downward spiral that can mean the virtual disappearance of markets.

Ditto with insurance. Patients know better than insurance companies how good their health is. The most unhealthy people buy the most insurance. Insurance companies suffer losses, and hence raise premiums. But this can make premiums excessively high for healthy people, who may progressively withdraw, leaving an even larger proportion of unhealthy people in the insurance market.

Banks cannot identify the most creditworthy small borrowers, and so charge all of them high interest rates. The best small businessmen refuse to borrow at such high rates, leaving the market with more low-quality businessmen. These are more likely to default, driving banks to raise interest rates still higher, and reducing still further the quality of borrowers.

Clearly, information problems can spoil markets. But the solution rarely lies in government command and control. The Soviet Union eliminated information asymmetry by nationalising producing as well as buying companies. Soviet planners viewed prices as a capitalist device, and replaced financial targets for companies by physical ones—so many tonnes or so many square metres of output. This aimed to focus managers on physical production rather than profits, and use all information available to match supply with demand.

Glass factories, for instance, were set targets in tonnes. Managers responded by producing the thickest possible glass to maximise tonnage. But this meant fewer square metres of glass, causing shortages for construction, as also excessive breakage of over-heavy glass. Soviet planners decided to reset targets in terms of square metres. The result: managers made the thinnest possible glass to maximise square metrage. This ultra-thin glass shattered easily when transported or handled, so once again there was a glass shortage. Critics called it glass-nost.

Why do market economies fare better? Because they are based on prices, which incorporate a wealth of information. Demand comes from millions of consumers, and production from dozens of factories. Some consumers want thinner glass and some thicker. Some will sacrifice quality for a lower price, others will pay through the nose for high quality. The attitudes of each consumer and producer keep changing. No planning system can track these changes, but markets can. As demand and supply for every variety of glass keep changing, prices change accordingly. A rising price signals higher demand and spurs higher production. A falling price does the opposite. The market acts like a giant computer, matching signals from millions of consumers and dozens of producers. This enables the market, with all its imperfections, to handle information far better than the most sophisticated planners.

In practice, planners are not sophisticated. Mao’s Great Leap Forward led to 30 million starvation deaths. Officials did not dare tell Mao that his programme was failing. So Mao had no idea of the impending disaster and took no steps to avert it. The biggest information failure in history was a communist one.

Decades ago, Friedrich von Hayek won a Nobel prize for first recognising the computer-like ability of the market. He pioneered information economics long before this year’s winners.

How do we rectify the market for lemons? Not by uninformed government officials fixing prices. The solution in the West has come from warranties. Toyota, for instance, will inspect and repair a second-hand car, and warrant its performance for the next 100,000 miles. This provides symmetrical information to buyers and sellers, and the market performs normally again.

Why is certification by Toyota superior to that by a government inspector? Because, unlike the inspector, Toyota stakes its reputation, built at enormous cost, and backs this with a warranty.

What is the solution in insurance markets? First, companies offer rebates for group insurance. This covers entire companies or societies, and so has an appropriate mix of healthy and unhealthy persons.

Second, insurance companies insist that clients pay a certain minimum sum, called a deductible, before getting insurance benefits. So the patient is the first sufferer if he fails to take normal precautions (what economists call moral hazard). Third, companies insist that clients share the costs of treatment: typically, the insurance company pays 80 per cent of the cost and the patient 20 per cent. This reduces the possibility that clients will attempt risky activities, like para-gliding, on the assumption that injuries will be costless. These measures work better than government-fixed premiums.

In a few cases, government oversight works better. Banking systems typically have a government-appointed supervisor to stem excesses. Supervisors lay down norms for capital adequacy and recognising bad loans. This exposes risky lending and cilitates remedial action. Supervisors should ideally be independent authorities, insulated from the pulls and pressures of party politics. If not, loan melas and bad loans to cronies of politicians will proliferate.

We must thank Akerloff for his theory of lemons. But we must thank Hayek even more for showing that the biggest lemon of all is a command economy. The market for that particular lemon has shrunk and virtually disappeared, as predicted by Akerloff.

Good riddance.

What do you think?