Was George Akerlof Right on the Market Failure of Asymmetric Information?

Bart Remes

Bart Remes

Bart Remes is the founder of Economics in Action, an international coaching, training and strategy provider.

The law of gravity works everywhere on our planet. Yet at some places, gravity doesn’t work. Few people know this. For some strange reasons, people and objects start floating into space. It is annoying and very dangerous and requires action by authorities.

Physicists call this phenomenon Gravity Failure.

If you think this sounds like total nonsense, you are absolutely right. There is no such thing as Gravity Failure. It doesn’t exist.

In mainstream economics there is a similar phenomenon. It is called Market Failure. It runs like this:

“Free markets work fine everywhere on our planet. But for some strange reasons, sometimes they don’t. It is annoying and very dangerous and requires action by authorities.”

Unlike Gravity Failure, Market Failure is widely accepted in the economics profession. Market Failure comes in various forms. There are so-called natural monopolies, there are cartels, externalities, path dependence, free rider problems and asymmetric information.

 

MR. AKERLOF

In 1970, a Mr. George Akerlof wrote a pioneering article titled The Market for Lemons: Quality Uncertainty and the Market Mechanism. It was published in the American Economic Review. The article is known as the lemon’s problem in economics. It alludes to troubles caused by asymmetric information.

Mr. Akerlof is the husband of Mrs. Janet Yellen, an earlier chairman of the US Federal Reserve. Husband and wife surely are a power-couple in the economics profession.

In 2001 Mr. Akerlof received the Nobel Prize Economics – along with Michael Spence and Joseph Stiglitz – for their analyses of markets troubled by asymmetric information.

The story of the lemons goes like this:

A second-hand car dealer has more information about the quality of a used car than the buyer. He is in a position to rip off the buyer by selling him a Lemon, that is, a bad car. Don’t trust that man. It is a clear case of asymmetric information. It is a very serious market failure.

Mr. Akerlof predicted that, as a result of this very serious market failure, the whole used car market would disappear. He spiced up his article with sufficient mathematical formulae to subtly imply to the intrigued reader that I am smart and you are dumb. I am right and you are wrong. And there is nothing you can do about it.

 

MR. WORMWOOD

Mr. Wormwood is the perfect example of the second-hand car salesman Mr. Akerlof has mind. He is a fictional character in Matilda, a delightful children’s book written by the brilliant Roald Dahl. In 1996 Matilda was made into a movie, with Mr. Wormwood played – majestically – by a grand Danny De Vito.

In the movie there is a scene where Mr. Wormwood gives a spectacular masterclass to his young children Michael and Matilda. He attempts to educate in the art of selling a Lemon.

Attach the bumpers with super – super – glue instead of welding, reverse the odometer with a drill, pour sawdust in the gearbox so that the engine runs sweet as a nut… at least for a short while.

When Matilda tells her father that this is not an honest way to do business, Mr. Wormwood not so subtly implies that I am smart and you are dumb. I am big and you are little. I am right and you are wrong.

And there is nothing you can do about it.

Or so he thought … hint, watch the super – super glue. Double Bingo!

Mr. Wormwood may be the epitome of the not-so-honest second-hand car sales man. But he does not create market failure. He is just a cheater.

 

RISK REVERSAL

The idea of risk is very important in free markets. Risk significantly impacts the value of all goods and services. In any transaction one party is always being asked to accept more risk than the other party.

Buyers typically think they always take more risk – being ripped off, making the wrong choice, looking dumb… buying a Lemon.

Sellers counter this by implementing risk reversal, a term invented by business-growth strategist Jay Abraham. The idea is to overcome risk by taking it away from the buyer. Key is to describe risk reversal in plain language.

‘100% guarantee! Try it, use it, and I give you all your money back. No questions asked’

When described like this, the whole thing is guaranteed. The buyer’s risk is gone.

Surely, at times the seller will have to pay the money back, but according to Mr. Abraham, reality is that by adding incomparable, powerful and irresistible risk reversal to the offer, sales boost by 100 or even 500 percent.

 

CAR MAX

Car Max was established 23 years after Mr. Akerlof wrote his famous article. Today Car Max is the USA’s biggest second-hand car retailer. The company employs 25,000 people and is listed on the New York Stock Exchange. Its market value is about 14 billion USD.

Not a bad feat for a company that according to some economic thinkers should not even exist.

When you buy a used car from Car Max you get five days to take your car back ‘no questions asked’. Then there is a 30-day warranty. In addition, you can buy inexpensive extended warranties.

Car Max is the obvious proof that there is no Market Failure in the second-hand car market.

 

PAINFUL DETAIL

And all this is true. Asymmetric information is reality. Some people know more about things than other people. Nobody knows everything.

In 1970, at the time of Mr. Akerlof’s writing, second-hand car retailers already offered warranties. The very problem of asymmetric information that Mr. Akerlof complained about was solved already.

Nonetheless, today there exists huge literature about market failure. Why?

It is simply easy to posit stuff like ‘I, the buyer of a second-hand car, don’t know as much as a salesman who is selling me the thing’. Or ‘I, the consumer of a steak, don’t know as much as a farmer who raises cattle and brings steak to market.’

And all this is true. Asymmetric information is reality. Some people know more about things than other people. Nobody knows everything.

But asymmetric information is basically why markets exist! Another word for it would be the division of labour and knowledge. We all have specialities in knowledge of something in our work lives, and we make money out of that. I make money getting results for my customers, growing their business, growing their profits. And I use that money to buy things like my home and beers.

 

FORMULA TO FAILURE

What are economists like Mr. Akerlof really thinking? Have they lost their marbles? Why are their ideas so out of this world? Are their brains affected by exposure to Gravity Failure?

In my view, the thinking about Market Failure can best be summarised by a simple linear equation.

Market Failure = Nirvana – Entrepreneurs + Armchairs (*)

Here is what that means.

(*) Please note that Lemons are not part of the equation.

 

NIRVANA

Around the 1930s the theory about competition changed dramatically. All the suddenly the thinking went from dynamic rivalrous entrepreneurship to this weird thing called perfect competition. It says that many firms produce homogeneous products, at homogeneous prices, with costless entry and exit, and everyone has perfect information.

Basically, economists theorise that ‘this is what perfection is’. And then compare this bizarre utopia to the real world.

Naturally, the real world falls short. After all, nothing on this planet is perfect. The conclusion of perfect competition is that there must be plenty of Market Failure out there.

Harold Demsetz – a common sense Professor at the University of California LA – coined this thinking Nirvana Fallacy. Nobel Prize winner Friedrich von Hayek concluded in The Meaning of Competition that in perfect competition there is no competition – it is all assumed away. Now that is real Nirvana!

 

MISSING ENTREPRENEURS

Many Market Failure stories are merely based on the presence of some externalities. Externalities are the negative side of an economic activity. According to theory, externalities only can be solved through regulation, more regulation, regulation encore, and legislation. And also taxes of course. And taxes on taxes. Or simply ban the economic activity.

The American humourist and libertarian – P.J. O’Rourke – dryly noted that ‘When buying and selling are controlled by legislation, the first things to be bought are legislators.’

People are not dumb. People are problem solvers – at least some us are – especially when there is money to be made, someone is going to figure out how to make that money. I don’t know and cannot imagine what saltwater beer tastes, but here is a story about such beer.

In South-Florida there is a saltwater brewery aptly called Saltwater Brewery. Naturally, living at the coast there are all these stories of fish choking to death on plastic six-pack rings.

In order to set themselves apart from the competition, the guys a Saltwater Brewery hired a chemist and figured out how to make six-pack rings that are good enough to hold cans of beer and when thrown in the sea, the fish will eat them!

They got an order from Anhauser Bush for 50,000 of these things. That was just a first order. But if you sell 50,000 of anything, that is a good piece of change. There was money in it.

They didn’t necessarily do it solely because they felt sorry for the fish. They are entrepreneurs and created a solution to a problem. And became rich doing that.

 

ARMCHAIR ECONOMISTS

Economists like Mr. Akerlof never spend time getting up from the swivel chair and leave the faculty offices. They are theorising all day long without ever looking out of the window to see if the world matches their theories.

The Fable of the Bees and the Apple Orchard is a good example of blackboard – or whiteboard – theorising. It is an article written in 1952 by James Meade, a Professor of economics at the Massachusetts Institute of Technology (MIT). The article appeared in all economic textbooks in the 1950s, 1960s and 1970s.

It is a situation of beekeepers near an apple orchard. The bees are pollinating the apple orchard. As a result, the apple grower has more apples.

This is serious Market Failure according to Mr. Meade because there is no mechanism for the farmer to pay the beekeeper.

Admittedly, there is some reciprocity because the apple trees provide food for the bees … but there is no mechanism for collaboration between the beekeepers and the apple tree owners.  Market Failure there shall be!

To correct this situation, Mr. Meade recommended that the government should start subsidising beekeepers. Some say Mr. Meade was a beekeeper on the side next to him being a Professor at MIT.

In comes Steven Cheung, a Professor at the University of Washington. Washington is a big apple growing state. Now, Mr. Cheung did something almost unheard of as an academic economist. He jumped off his bud and left the office! He decided to educate himself about the beekeeping and apple growing industries.

What he found is that for generations there were implicit and explicit contracts (very detailed!) between beekeepers and apple orchard owners. The contracts would say things like ‘If we are going to spray bug killing poison on our apple trees, we have to give the beekeepers two weeks-notice so that they can get the hives away to avoid the bees being killed by the poison we use to kill the other bugs.’

And… they had payments going in both directions, depending on the situation of the apple orchard and the bees.

What Mr. Cheung found was that for many generations these business people – entrepreneurs – were not as dumb as economists like Mr. Meade (don’t forget Mr. Akerlof) had assumed.

There was money to be made by collaborating between the beekeepers and the apple orchard owners. And… sure enough, if there is money to be made, somebody will figure out how to make that money.

 

CONCLUSION

A quote from John Kenneth Galbraith:

‘Economics is extremely useful as a form of employment for economists.’ Sadly, there is truth in these words.

By ignoring the whole process of markets, too many economists tend to not even think about private solutions. They just assume there is no end to it.

Markets process. Markets clear. Markets work.

Market Failure is as elusive as Gravity Failure. It doesn’t exist.

 

SPECIAL THANKS

The fishes at South-Florida coast say a ‘Big Thank You’ to the guys at Saltwater Brewery.

Mr. Akerlof sent me a ‘Big Thank You’ for tipping him off about Mr. Wormwood’s cars. He cancelled his order.

The apple tree owners near MIT received a ‘Big Thank You’ from their favourite beekeeper – a certain Mr. Meade – after they sent another cheque for pollinating their apple trees

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Bart Remes

Bart Remes

Bart Remes is the founder of Economics in Action, an international coaching, training and strategy provider.