Economics concepts and applications

Economics

Doing business in emerging markets can be risky. If the risk of something like corruption was known, it could be priced into a transaction. With the costs of dishonesty are not known, however, that represents asymmetric information that may discourage investment altogether. Using the analogy of a used car market, Akerhof explains the importance of discouraging dishonesty to the maintenance of a healthy, functioning market.

Akerlof writes about the "market for lemons," discussing the issue of the economic costs of dishonesty. His model is the used car market, where there are vehicles of varying grades, each unique, and dishonesty about the quality can have an effect on the price of the vehicle. The article seeks to uncover some truths about how these types of markets operate. He points out that information asymmetry is like dishonesty, in that one party does not know what the intent of the other party is. Eventually, this can lead to market failure. This situation is applicable to developing nations as well, where dishonesty and corruption are a form of information asymmetry. Akerhof shows how dangerous this can be for an economy -- up to and including market failure.

Response to Question #1

Akerlof notes that there is asymmetric information in the used car market in that the seller always knows more about the quality of the car than does the buyer. A buyer may not be able distinguish between vehicles of differing quality, if there is no differential in the price. He notes that this can lead to market failure. His argument is that bad vehicles can drive out the market for better vehicles. Buyers can become suspicious, so that they are unwilling to purchase. This takes down the market not only for the lemons but for anything that might look like a lemon. He argues this point based on utility, in that a buyer who is unable to differentiate between quality levels is unable to ascertain utility. This reduces the likelihood that the buyer would even purchase any car. The market could, in theory, fail entirely, although the author notes that this is unlikely to occur in the real world.

Response to Question #2

Akerlof argues that the market corrects this. He uses the analogy of the insurance business, where higher insurance rates reduce demand, so that at high rates only customers fairly certain that they will need insurance will buy it. In the use auto market, sellers can signal to buyers that quality and price are related. This can help to alleviate the asymmetry of information between them. If sellers do that consistently, then buyers will gain trust in the sellers that price is in fact related to quality. When that happens, the market can function because buyers can be fairly certain of their utility.

What this refers to is the cost of dishonesty. In used cars, dishonesty will drive away business, so any car lot with an interest in long-term success must ensure that the costs of dishonesty are reduced by reducing dishonesty itself. He then likens the lemon market to the cost of doing business in a country with high levels of corruption. Firms are discouraged from investing in places where information asymmetry means that they cannot distinguish between a good business opportunity and a scam. Thus, again, encouraging a lack of corruption would be the best pathway to successful business promotion, just as it is on a used car lot.

Conclusion

Akerhof shows with the used car example how high the costs of dishonesty can be. For those in public policy or in business, this is an important finding. When dishonesty is likened to information asymmetry, the economic implications become clear -- there are high costs associated with dishonesty, and this holds a lot of countries back. He argues that if honesty is implemented, the market will grow stronger.