Thursday, March 12, 2009

Rejected submission on lemons

In my youthful past when I sent an article to an academic journal and it was rejected my reaction was often one of fury.  This was often amplified by the fact that many referee reports are dismissive and careless*.  These days I still occasionally get angry but I have also become more philosophical as a product of what must be hundreds of interactions with editors and referees.

George Akerlof's paper on 'lemons' is one of the beautiful contributions I have come across in microeconomics. It shows depth of vision.  It changed the way we do microeconomics and the role we advocate for markets.

Akerlof considers a car vendor selling second-hand cars that may either be 'quality vehicles' or 'lemons'. It is a standard market situation except for one thing - the vendor has better information about the quality of the cars sold than potential purchasers. This is asymmetrical information. Potential customers will drop their bid for a car below the price of a 'quality car' because they will suspect there is some probability the car might be a 'lemon'. On the supply side fewer people will wish to trade in their 'quality' vehicles if bidders offer a reduced price.  Thus iterating again the thought process of the buyer there will be an increased probability that any car is a lemon.  Again this will influence the decision to sell a 'quality' used car and so on...... 

The upshot might be that the market for second hand quality cars disappears completely - or is greatly dinminished - as a consequence of the knowledge advantage of the car vendor.  It is a brilliant insight with a host of applications in real markets - in health, education and in various professional services for example.

Akerlof made many valuable contributions in economics apart from the 'lemons' problem. Indeed I referred to his interesting work on behavioural macroeconomics on this blog.  He was awarded the Nobel Prize in economics.  In this interesting note Akerlof discusses the process of writing and submitting the 'lemons' paper. It was repeatedly rejected by leading journals in economics as 'trivial' but was anything but that.

* This carelessness doesn't always prevent publication. I have submitted one paper that I am now convinced was wrongly accepted. I am not saying where this is.

9 comments:

jc said...

the vendor has better information about the quality of the cars sold than potential purchasers.

I'm not sure that's exactly true.

1. the seller and the buyer could be both in the void as the problem could show up 10 ks into the future.

2. The seller and buyer can both avail themselves of an inspection.

conrad said...

If you read Kahneman's Nobel prize speech, he has much the same experience. His famous paper on representativeness was rejected by the top psychology journal, and apparently the reviewer even patronized him for it!

As for me -- I think I could plaster my office with rejection letters if I tried.

observa said...

Akerlof obviously hasn't sold used vehicles for a living or he wouldn't write such claptrap. While it's true more often than not, the vendor knows more about the vehicle than the purchaser, it's that very expertise the buyer relies on not to get a lemon, which he has much more chance of when buying privately. Unlike the private seller, the dealer wants your repeat business and that of your family, friends and associates. OTOH the private seller, disposing of the odd car every few years couldn't care less and what's more may not know its market value any better than the buyer. The dealer will know its market value (ie its inherent value for money)
Let me explain how that works. Not everyone can afford a new car or even a one or two year old one and cars will vary from maxm life to come when new, to a spectrum in between to ready for the wreckers. Now the price you pay for any of that used spectrum must reflect that fairly and I would be comfortable trading/buying an older/dowdy but mechanically reliable vehicle for the right price. In other words I had to feel it would give the next owner relaible value for money. I would often reject pretty hand grenades, with serious faults the seller was trying to pass off at a price I couldn't rectify and sell as fair value, only to see them privately advertised and sold to some poor sucker the next weekend. As well before the Vehicles Security Register made life easy (we were members of a private credit checking agency)I had all sorts of shucksters and fraudsters trying to flog me vehicles under finance,only to see them selling them privately when dealers like me gave them short shrift. Used motor vehicle dealers offer the seller a professional service which many are happy to pay for and rightly so. Drive in with your older car and drive out in the newer one, hassle free at the right price. The used vehicle game like any other has its Madoffs, Adlers, Skases like any other but they don't last long in the same place.

observa said...

As an old horsetrader divulged to me early on(from recall)-
Son it's like this in the pre-loved vehicle game. There's a unique vehicle out on that concourse to suit every taste and budget walking in here and noone's got exactly the same one as us and it's up to you to be the matchmaker and keep all that love flowing. The other important thing to remember is you can sell anything if the price is right, even if you have to pay someone to take it away and that's called rubbish!
Akerlof should have had a decent chat with that born economist millionaire that left school at 15.

MkeM said...

Observa,

If all else failed you could try getting hold of a copy of Akerlof's paper - or at least reading the Wikipedia article to which Harry linked - to understand the thrust of Akerlof's argument.

In the almost 40 years since the paper appeared there have been changes in the used car market, for better (warranties offered by dealers for example, reliability and user satisfaction surveys by consumer organisations) and for worse (vehicles have become immensely more complicated).

The used divisions of new car dealers might espouse the ethics that you claim for the reasons that you claim, but I've never seen evidence that the bulk of used dealers think this way.

derrida derider said...

observa once again shows that ignorance is no barrier to opinion in the blogosphere. Observa - before you criticise it, read the bloody paper.

Not least of its virtues is that it is so clearly written that any fool can follow the argument. The lack of obfuscation was no doubt a factor in its rejection by journals.

One of the ironies here, Observa, is that Akerlof himself has pointed out that the lemons problem - "if the horse was any good you wouldn't be selling it" - has been a commonplace understanding amongst horse traders for centuries.

Mind you, I do think the used car market for lemons is far less marked than it once was simply because there are far fewer genuine lemons and they're covered by long factory warranties (long warranties made economic for the factories, of course, by the rarity of lemons). We've shifted to a new equilibrium.

OTOH people in private car ads still fell the need to put in things like "genuine reason for sale" to try and signal its not a lemon.

hc said...

JC, This is a parable that attempts to provide insights - it is not intended to be a detailed analysis of used car markets. Of course given the asymmetrical info you will seek guarantees, inspection services etc. Likewise Observa the possibnility of repeat buying changes things - then reputation matters.

It is a beautiful article because it throws light on so many things.

observa said...

Let's be clear here. The vehicle market has changed much over my lifetime. The strife's new Mitsubishi Colt came with a 5yr/100000km roadside assist, transferable, overall warranty and a 10yr/160000km non-transferrable, power train, warranty for the new buyer(engine and CVT transmission)That's a far cry from when the O was a lad and you could buy a monday morning, brand new lemon straight off the production line. The Japanese with their absolute quality control that the 1st and 100000th car off the line were exactly the same top quality, would shake Anglo manufacturing to its foundations and make modern warranties the norm. I cut my teeth in the motorcycle industry as pommy bikes were decimated by the Japs. The legendary Honda 750 four(1968) was not only amazing for its outside and overall performance, but for what was then inside it. The two matched crankcase halves that clamped the 5 alphabet coded(ABCDE), varying tolerance plain bearing shells around its crankshaft told the story. They each varied by one fifth of a thousandth of an inch and as the tooling wore by that tolerance, so the next shell was selected until tool change time. It didn't take long for the market to appreciate that engineering and avoid the old in their droves. Modern new vehicle warranty world-wide was being born right then and there in the marketplace, leaving legislators to cotton on much later as per usual.

Value for money in the marketplace has changed much since millionaire Ray began putting that oil in his veins after the war and I doubt the old folks home has got the grease from under those fingernails yet. He never owned a new car in his life, driving a preloved Yank tank for much of the time I knew him, although he owned some restored classics that would be worth more than most new car offerings in the showroom today. You couldn't pick him as a millionaire unless you knew him but he never had to avoid anyone he sold a car to in his life. Far from it, as he traded fairly and squarely with their offspring and taught us to do the same. Yes we were often in an asymmetric position to stitch some greenhorn up with an overpriced deal, but as Ray knew only too well, the customer would work it out eventually and as bad news travels faster than good you were only shooting yourself in the foot for the long walk through business life. That ethos and discipline never left me and so many of his apprentices, not to mention his son and grandson.

OTOH as a trader you were so often assailed by private owners with no such scruples trying to put one over you and ultimately your customers. You had to know your stuff or perish under that onslaught and I could fill an interesting evening with the tales. The marketplace tells us Akerlof's insight is largely wrong overall about the used vehicle game, since most used buyers use it again and again for the very reasons I outline. They're happy to pay a fair price for valued expertise and often recognise what Ray did, that used vehicles can often represent better value for them personally than new ones. Would you rather have bought a new Leyland P76 off the showroom floor or a 3 or four year old one from Ray? The former might be a 'lemon' whereas when Ray resold it to you it might not. That's what millionaire Ray could have explained to Akerlof more succinctly than I ever could as he waved him goodbye in a pre-loved car, until the next time. 'Nobel prize in microeconomics eh?', he'd chuckle quietly to himself.

Cori said...

@ jc:

1. the seller and the buyer could be both in the void as the problem could show up 10 ks into the future.No, even in that case the seller knows whether the problem has manifested itself during the period of ownership. The buyer does not.

2. The seller and buyer can both avail themselves of an inspection.Here you are actually offering evidence that the theory is correct. By employing a middle man, the buyer can overcome the information asymmetry and, in effect, gain some of the knowledge already held by the seller.