“Lemons” and Other Examples of Imperfect Information

Consider Marvin, who is trying to decide whether to buy a used car. Let’s assume that Marvin is truly clueless about what happens inside a car’s engine. He is willing to do some background research, like reading Consumer Reports or checking websites that offer information about makes and models of used cars and what they should cost. He might pay a mechanic to inspect the car. Even after devoting some money and time collecting information, however, Marvin still cannot be absolutely sure that he is buying a high-quality used car. He knows that he might buy the car, drive it home, and use it for a few weeks before discovering that car is a “lemon,” which is slang for a defective product (especially a car).

Imagine that Marvin shops for a used car and finds two that look very similar in terms of mileage, exterior appearances, and age. One car costs $4,000, while the other car costs $4,600. Which car should Marvin buy?

If Marvin was choosing in a world of perfect information, the answer would be simple: he should buy the cheaper car. But Marvin is operating in a world of imperfect information, where the sellers likely know more about the car’s problems than he does, and have an incentive to hide the information. After all, the more problems that are disclosed, the lower the car’s selling price.

What should Marvin do? First, he needs to understand that even with imperfect information, prices still reflect information. Typically, used cars are more expensive on some dealer lots because the dealers have a trustworthy reputation to uphold. Those dealers try to fix problems that may not be obvious to their customers, in order to create good word of mouth about their vehicles’ long term reliability. The short term benefits of selling their customers a “lemon” could cause a quick collapse in the dealer’s reputation and a loss of long term profits. On other lots that are less well-established, one can find cheaper used cars, but the buyer takes on more risk when a dealer’s reputation has little at stake. The cheapest cars of all often appear on Craigslist, where the individual seller has no reputation to defend. In sum, cheaper prices do carry more risk, so Marvin should balance his appetite for risk versus the potential headaches of many more unanticipated trips to the repair shop.

Similar problems with imperfect information arise in labor and financial capital markets. Consider Greta, who is applying for a job. Her potential employer, like the used car buyer, is concerned about ending up with a “lemon”—in this case a poor quality employee. The employer will collect information about Greta’s academic and work history. In the end, however, a degree of uncertainty will inevitably remain regarding Greta’s abilities, which are hard to demonstrate without actually observing her on the job. How can a potential employer screen for certain attributes, such as motivation, timeliness, ability to get along with others, and so on? Employers often look to trade schools and colleges to pre-screen candidates. Employers may not even interview a candidate unless he has a degree and, sometimes, a degree from a particular school. Employers may also view awards, a high grade point average, and other accolades as a signal of hard work, perseverance, and ability. Employers may also seek references for insights into key attributes such as energy level, work ethic, and so on.

How Imperfect Information Can Affect Equilibrium Price and Quantity

The presence of imperfect information can discourage both buyers and sellers from participating in the market. Buyers may become reluctant to participate because they cannot determine the quality of a product. Sellers of high-quality or medium-quality goods may be reluctant to participate, because it is difficult to demonstrate the quality of their goods to buyers—and since buyers cannot determine which goods have higher quality, they are likely to be unwilling to pay a higher price for such goods.

A market with few buyers and few sellers is sometimes referred to as a thin market. By contrast, a market with many buyers and sellers is called a thick market. When imperfect information is severe and buyers and sellers are discouraged from participating, markets may become extremely thin as a relatively small number of buyer and sellers attempt to communicate enough information that they can agree on a price.

When Price Mixes with Imperfect Information about Quality

A buyer confronted with imperfect information will often believe that the price being charged reveals something about the quality of the product. For example, a buyer may assume that a gemstone or a used car that costs more must be of higher quality, even though the buyer is not an expert on gemstones. Think of the expensive restaurant where the food must be good because it is so expensive or the shop where the clothes must be stylish because they cost so much, or the gallery where the art must be great, because it costs so much. If you are hiring a lawyer, you might assume that a lawyer who charges $400 per hour must be better than a lawyer who charges $150 per hour. In these cases, price can act as a signal of quality.

When buyers use the market price to draw inferences about the quality of products, then markets may have trouble reaching an equilibrium price and quantity. Imagine a situation where a used car dealer has a lot full of used cars that do not seem to be selling, and so the dealer decides to cut the prices of the cars to sell a greater quantity. In a market with imperfect information, many buyers may assume that the lower price implies low-quality cars. As a result, the lower price may not attract more customers. Conversely, a dealer who raises prices may find that customers assume that the higher price means that cars are of higher quality; as a result of raising prices, the dealer might sell more cars. (Whether or not consumers always behave rationally, as an economist would see it, is the subject of the following Clear It Up feature.)

The idea that higher prices might cause a greater quantity demanded and that lower prices might cause a lower quantity demanded runs exactly counter to the basic model of demand and supply (as outlined in the Demand and Supply chapter). These contrary effects, however, will reach natural limits. At some point, if the price is high enough, the quantity demanded will decline. Conversely, when the price declines far enough, buyers will increasingly find value even if the quality is lower. In addition, information eventually becomes more widely known. An overpriced restaurant that charges more than the quality of its food is worth to many buyers will not last forever.

Mechanisms to Reduce the Risk of Imperfect Information

If you were selling a good like emeralds or used cars where imperfect information is likely to be a problem, how could you reassure possible buyers? If you were buying a good where imperfect information is a problem, what would it take to reassure you? Buyers and sellers in the goods market rely on reputation as well as guarantees, warrantees, and service contracts to assure product quality; in the labor market, occupational licenses and certifications are used to assure competency, while in financial capital market cosigners and collateral are used as insurance against unforeseen, detrimental events.

In the goods market, the seller of a good might offer a money-back guarantee, an agreement that functions as a promise of quality. This strategy may be especially important for a company that sells goods through mail-order catalogs or over the web, whose customers cannot see the actual products, because it encourages people to buy something even if they are not certain they want to keep it.

L.L. Bean started using money-back-guarantees in 1911, when the founder stitched waterproof shoe rubbers together with leather shoe tops, and sold them as hunting shoes. He guaranteed satisfaction. However, the stitching came apart and, out of the first batch of 100 pairs that were sold, 90 pairs were returned. L.L. Bean took out a bank loan, repaired all of the shoes, and replaced them. The L.L. Bean reputation for customer satisfaction began to spread. Many firms today offer money-back-guarantees for a few weeks or months, but L.L. Bean offers a complete money-back guarantee. Anything you have bought from L.L. Bean can always be returned, no matter how many years later or what condition the product is in, for a full money-back guarantee.

L.L. Bean has very few stores. Instead, most of its sales are made by mail, telephone, or, now, through their website. For this kind of firm, imperfect information may be an especially difficult problem, because customers cannot see and touch what they are buying. A combination of a money-back guarantee and a reputation for quality can help for a mail-order firm to flourish.

Sellers may offer a warranty, which is a promise to fix or replace the good, at least for a certain period of time. The seller may also offer a buyer a chance to buy a service contract, where the buyer pays an extra amount and the seller agrees to fix anything that goes wrong for a set time period. Service contracts are often used with large purchases such as cars, appliances and even houses.

Guarantees, warranties, and service contracts are examples of explicit reassurance that sellers provide. In many cases, firms also offer unstated guarantees. For example, some movie theaters might refund the cost of a ticket to a customer who walks out complaining about the show. Likewise, while restaurants do not generally advertise a money-back guarantee or exchange policies, many restaurants allow customers to exchange one dish for another or reduce the price of the bill if the customer is not satisfied.

The rationale for these policies is that firms want repeat customers, who in turn will recommend the business to others; as such, establishing a good reputation is of paramount importance. When buyers know that a firm is concerned about its reputation, they are less likely to worry about receiving a poor-quality product. For example, a well-established grocery store with a good reputation can often charge a higher price than a temporary stand at a local farmer’s market, where the buyer may never see the seller again.

Sellers of labor provide information through resumes, recommendations, school transcripts, and examples of their work. Occupational licenses are also used to establish quality in the labor market. Occupational licenses, which are typically issued by government agencies, show that a worker has completed a certain type of education or passed a certain test. Some of the professionals who must hold a license are doctors, teachers, nurses, engineers, accountants, and lawyers. In addition, most states require a license to work as a barber, an embalmer, a dietitian, a massage therapist, a hearing aid dealer, a counselor, an insurance agent, and a real estate broker. Some other jobs require a license in only one state. Minnesota requires a state license to be a field archeologist. North Dakota has a state license for bait retailers. In Louisiana, a state license is needed to be a “stress analyst” and California requires a state license to be a furniture upholsterer. According to a 2013 study from the University of Chicago, about 29% of U.S. workers have jobs that require occupational licenses.

Occupational licenses have their downside as well, as they represent a barrier to entry to certain industries. This makes it more difficult for new entrants to compete with incumbents, which can lead to higher prices and less consumer choice. In industries that require licenses, the government has decided that the additional information provided by licenses outweighs the negative effect on competition.

On the buyer’s side of the labor market, a standard precaution against hiring a “lemon” of an employee is to specify that the first few months of employment are officially a trial or probationary period, and that the worker can be let go for any reason or no reason after that time. Sometimes workers also receive lower pay during this trial period.

In the financial capital market, before a bank makes a loan, it requires a prospective borrower fill out forms regarding the sources of income; in addition, the bank conducts a credit check on the individual’s past borrowing. Another approach is to require a cosigner on a loan; that is, another person or firm who legally pledges to repay some or all of the money if the original borrower does not do so. Yet another approach is to require collateral, often property or equipment that the bank would have a right to seize and sell if the loan is not repaid.

Buyers of goods and services cannot possibly become experts in evaluating the quality of gemstones, used cars, lawyers, and everything else they buy. Employers and lenders cannot be perfectly omniscient about whether possible workers will turn out well or potential borrowers will repay loans on time. But the mechanisms mentioned above can reduce the risks associated with imperfect information so that the buyer and seller are willing to proceed.