Lemons principle – Interesting inputs for entrepreneur


 Have you heard by Lemons principle by George A. Akerlof? It says the presence of people in market who are ready to offer “Inferior Goods” tend to wipe out the market out of existence, if it is not possible to identify good ones from bad. George A. Akerlof is a noble prize winner 

It is a very nice simple principle and can be best illustrated by “Unorganized Used Car Market”. Taking the fact that not many sellers are ready to disclose the real conditions of the car, people value any car in the market using law of averages. Assuming a good car is worth 80,000 and bad car is worth 50,000, then buyers assuming there would be 30% chance to get a good car may ready to buy it at an average weighted price of 59000. As this price of 59000 doesn’t make sense for a good seller whose car is worth 80000, the good sellers may stop selling it in the Unorganized Market and resulting in complete extinction of the “Unorganized used car market” over a period of time as there would be only bad sellers 

Does it answer the reasons why people hesitate to buy a used car from someone unknown on basis of advertisements and also the reason behind mushrooming “Organized User Car” vendors in the country who try to bring in the confidence of the buyers by providing warranty for second hand used cars / disclosing the complete details of used car under sale etc? Off course all at a premium and that is their business 

So in general if you are a seller and that too in a service business where you are in “Lemons Situation”, you have to send the right signals to prospective buyers / customers by distinguishing yourselves from others to gain customer’s confidence in terms of the service contracts you offer. Typically good public listed companies easily distinguish themselves from others by paying higher dividends, higher returns, appointing reputed financial firms to scrutinize their results, having distinguished people as their board members, confirming superior standards of accountings and disclosures etc 

An interesting analysis also says a small investment on above “Signaling” (If you are good seller) can significantly bring down the cost of acquiring new customers / raising money from lenders at cheaper rates for your future growth and development of Business

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2 thoughts on “Lemons principle – Interesting inputs for entrepreneur

  1. The lemon theory can be misleading, I think. It assumes that value is created in mono/oligopoly and homogenous large scale demand. But sustainable value is created by diversity. One cannot blame if a business aims for monopoly -the earth is populous, material resources are scarce, the only plentiful resource is the brainforce, and so it seems rationale to avoid ‘wasting’ resources by competition.

    The practical problem of course is that there is no such thing as a rational business. It’s just a collection of rational individuals. And that’s for the good. Even the most frugal of the Popes has had an objective -to make the whole planet christian, and that’s but natural -it would make his life easier. The Pope exiled Galileo not because of what he said but for what he refused to say. Galileo was a lemon (it’s a different matter that the Church advises lemons for good health, and entirely another that the East has had a habit with lemons for ages).

    In practice a price-quality function can emerge and stick when the average price is decreasing or essentially when the product type becomes mass market. A mass market implies low or next to nil information asymmetry [in a constant avg price market, a low quality offer would go out of business through the factor markets (money, labour or goods market)].

    When I go to buy a Used Car I am expected to read the Usage and make my bargain with the seller. The lemon theory assumes that the individual buyer relies on the average statistics but that’s far from reality. The lemon theory conceptualises the market as an object but it’s just individuals buying and selling stuff. Everyone buys and pays exactly what they want to and if a product market ceases to exist it is because the seller and buyer could not meet at a price for the product.

    The Western industry, especially post-WW2, had to grapple with the twin realities of increasing technical advances leading to decreasing input costs and a simultaneous increase in labour costs. With the domestic markets getting commoditised and more efficient foreign competitors on the prowl in the international markets, it would have been a miracle if a price-quality continuum had not emerged! Someone had to do a namakarana, and so lemon it was/is.

    The “lemons” were innovative operations and caused counter innovations.

    The take away for me is that a business should work towards making lemons possible. i.e. drive down costs and prices low by removing information asymmetry, and when the lemons start emerging one gets to know even more of where the asymmetries exist and that information should be used to clear out the residuals, to eventually emerge the stronger having cleared out the roaches!…only to start the cycle again…

    Things like corporate transparency etc are certainly in that direction.

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