Free Market Institute Blog
How to Avoid a Lemon
When I made the decision to return to Wisconsin, my first mundane challenge was to buy a “preowned” (okay, used…) car. In mid 2022, I knew that, for a variety of reasons, used car prices had nearly doubled in about a year, so I figured, broadly speaking, I had two choices:
1: Buy a nice, dependable $12,000 Japanese sedan, or
2: Buy an ugly duckling, non-Japanese, $3000 clunker with some body damage.
I chose the clunker. Since trends tend to “revert to the mean,” I reasoned that the Covid-related rise in prices for used cars was a bit like a flying unicorn or a negative oil price. If I were to sell my car in a few years, its price would likely revert to the mean. Let’s assume that in a few years, used car prices will drop a third from the Covid era. Would I rather lose $4,000, or $1,000?
I chose the latter.
When you are thinking of purchasing a used car, though, you have a challenge, which economists call “asymmetrical information.” I know little about cars, and knew nearly nothing about my 2008 cherry red Passat with 189,000 miles; the owner, presumably, knew a bit more. But he didn’t have any incentive to tell me any bad information (I did notice the red duct tape on the front right side, though).
This “unbalanced information” is a problem, and it’s a problem everyone has or will have encountered for a variety of goods. Is Bill going to be a great employee or a fantasy football fanatic goofing off all day? Will Sue’s “Noodles Galore” be a gourmet delight, or warmed up ramen? Is that Apple iPhone worth the extra money to own? Is the “handyman’s special” home an awesome deal, or an awful money pit?
Of course, in the spirit of sharing, I shared my personal dilemma with my students by including it in an assignment: I asked my micro students to discover or devise solutions for a variety of asymmetric information problems.
This asymmetrical information problem actually illustrates two different approaches to challenges all markets face. The “standard” view is that information asymmetry reflects a “market failure,” which causes problems in an economy, which governments should solve—perhaps with a consumer protection bureau, a requirement for “full disclosure,” or a “lemon law.”
My view is different. Information asymmetry is not a market failure as much as it’s a market reality. The world is full of adults who can know and do know only so much. Each person knows a whole lot more about a variety of issues and goods than I know. Welcome to reality; it’s a humble acknowledgment that “I’m not God,” or even “I’m not Tom or Ray Magleozzi (“Click and Clack" on NPR).
And yes, it causes challenges. I wasn’t quite sure when, or if, my timing belt was replaced, which became an issue when the car’s odometer was pushing 200,000 miles. In fact, four months after I purchased the car, I found out it had a timing chain. Who knew? Not me.
But when we look at government solutions to market problems to informational asymmetries, we should always compare its solutions to market solutions, which I happily, and quite imperfectly, employed.
I checked CarFax. I had my mechanic examine the car (albeit after I purchased it; my bad). Though the car’s price was $3250, I offered only $3000, and was happy that the owner’s acceptance of my offer seemed to show a bit of reluctance. I test drove the car. I checked the cleanliness of the trunk.
True, none of the above “solutions” to my knowledge deficit was perfect; but setting up a government bureaucracy is likely to be more costly, and of course, shifting the responsibility for finding information to someone else would cause me to be even more reckless the next time I purchase a used car. This is true for a bank's bad loans, since the FDIC insures deposits, which causes both the customer and the banker to become more reckless—when was the last time you examined your bank’s financial statements?
Each time legislation shifts responsibility for information issues, unintended consequences result.
Think about stock purchases (if one doesn’t do their “due diligence” and loses money on a stock, but can sue the company for its bad quarterly results, why should anyone ever do due diligence?), restaurant meals, eBay purchases, and just about everything sold on Craigslist or Facebook Marketplace. And what about emails loaded with grammatical errors from long-lost Nigerian relatives?
Markets never solve any problem flawlessly, but they’ve provided pretty good solutions to the above problems of asymmetrical information. Insurance, warranties, branding, third party verification systems, and perhaps best of all, peer feedback mechanisms help mitigate information asymmetry. If your Uber driver has five stars, he is probably a decent driver who won’t kidnap you. I once found a bedbug in my hotel room, and asked management for a refund. They refused. I wrote a bad review, with a photo of the engorged creature.
I wonder how much that bad review cost the hotel. I wonder if that hotel is still in business.
Consider eBay, where we buy items from people we’ve never met and never will meet. And yet–how often are we ripped off? In my 20+ years of buying and selling on eBay, I always aim to please my customers, not so much because I’m an honest person, but more so because of that precious feedback score I’ve been curating for decades. Even if the customer is wrong, because I have over 3350 positive feedback ratings, I will move mountains to keep my 100% positive feedback rating intact.
We should never compare imperfection that exists in the real world with perfection in our personal utopia; otherwise, would any marriage survive? Any school? Any friendship?
When we look at markets, let’s never let an imagined perfection crowd out a pretty good solution.
Here’s to pretty good.
