Are You a Lemon?

The Lemon effect

The Lemon effect happens when, in a given market, sellers know more about the products being sold than buyers. (Lemon is an American slang term for a car that is found to be defective only after it has been bought).

If people wanting to buy a used car don't know which cars are bad and which aren't, they assume every car is a potential lemon... so they're only willing to pay lemons' prices for any car. Sellers, who know the difference, are not willing to offer good cars for the price of lemons.

Therefore, sellers of good cars withdraw from the market, creating a vicious circle: the greater chance one has to buy a lemon, the more weary buyers become. Eventually there are only lemons left.

Once you start thinking about the Lemon effect, you see it everywhere.

For instance, the Lemon effect explains the success of fast-food chains: it's not about quality or convenience (or speed) as much as it's about consistency. When you're out of town, a local restaurant is a gambit. McDonald's isn't.

And by the way, the whole point of the "methodology" of making Big Macs isn't to allow "idiots" to make acceptable hamburgers; it's to ensure consistency — which isn't the same thing. If McDonald's started to hire actual chefs in all of its restaurants, and let them be creative, they would be worse off, because patrons would have no way to tell which ones are good and which aren't, and going to McDonald's would involve the same uncertainty as going to the average local burger joint.

In fact, the Lemon effect is so important that simply removing it creates markets where none existed before: that's what Airbnb did.

Buyers and Sellers

But if certain institutions can help alleviate the Lemon effect (brands that offer a consistent and predictable experience, licences issued by a trusted authority, etc.), what are individual buyers and sellers to do?

Buyers can educate themselves, but it takes a lot of time and energy. It may be worthwhile if it's your job to buy a specific category of goods, but if you're in the market for just one item, it's unrealistic.

In that case you'd rather simply look for external clues that are fast to identify and process.

What about sellers? (Honest sellers, obviously.) For one thing, sellers can't educate buyers. If you're hoping to sell your car you cannot offer to turn even one prospective buyer into a mechanic (more than one, even less so).

Sellers can do two things:

  1. Send signals that the things they're selling are actually good (not lemons).
  2. Look for competent buyers

Signals are effective because buyers are actively looking for them. If you can build a brand, or offer the recommendation of a trusted authority, etc., more power to you. (Price is a signal, too.)

But signals hard to get right, because they are the first thing dishonest sellers will try to manipulate (to the point where too many good signals may be a bad sign). Therefore, valuable signals are the ones that are very hard to manipulate (those for which manipulation, even if possible, is so difficult that it's probably not worth the effort).

This is why we rely so much on "word of mouth" for advice on what to buy or which movie to see. We value the opinion of our friends not because they are our friends, but because we think they're hard to game. And sometimes we even value the opinion of strangers more than that of experts, because strangers are perceived as "real people" who are probably telling the truth, whereas to assess an expert's opinion you need to be one yourself.

Looking for competent buyers is also an excellent strategy for sellers, and one the most overlooked ones.

Intuitively, we tend to believe that the less the buyer knows, the better. We'll be able to show them the shiny paint and have them appreciate the leathery smell. This is only true if you're selling lemons, and even then, you will only be able to sell them at a lemon's price.

If you have a Picasso in your home, and you know it's the real thing, you won't put it up in a garage sale; but other times people do exactly that. Case in point: the labor market.

Don't be a lemon

Every year brings new "marketplaces" for IT contractors or developers, each with its own set of rules. Inevitably, after a while, all that's left are people selling their time for 5 bucks an hour against people looking to build whole dynamic web applications for $300.

Why does this keep happening? (This isn't "commoditization". Commoditization would require standards, and having many sellers providing the exact same product. Commoditization can't happen in a prototype economy.) These sites are the epitome of the Lemon effect... a case of Lemon cancer if you will. They attract incapable professionals and clueless buyers into an orgy of incompetence, while keeping everyone else out.

In the same vein, dealing with an HR person who isn't a competent professional in your field often feels very unpleasant. Why? Because they don't have a clue. One would think that their cluelessness makes them look at you with deference, but the opposite is true: because they can't evaluate your abilities, they assume you're a charlatan and treat you accordingly. This doesn't make them bad people; it's human nature. Think of yourself buying a car from a complete stranger.

There are many posts going around on the web about why you should try to negotiate a better salary and how to do it (see this for a recent example).

All sound advice, I guess; but the question is, if prospective employers (or clients) know how much you're worth, is there much to negociate about? If they don't, how will some negotiation tricks make them suddently change their mind? When they suggest a low price for your services, they're not only thinking you may be a lemon, they're assuming you actually are one, since if you weren't, you would laugh in their face and leave.

Let's end this post

So my point is this: lemon markets are not your problem; they're okay, you know... for lemons.

If you're not a lemon, you should be very careful not to appear as one — or near one. Incompetent buyers will always assume every item for sale is a dud. It's understandable: they've been burned before. In the secret of your heart, you should forgive them, but still avoid them like the plague. Say you're currently unavailable. Change numbers. Speak a different language.

Look for people who understand the quality of what you're selling. There's nothing better in this world than doing good work for people who can appreciate it.

Further reading

See the original paper from George Akerlof that would eventually earn him a Nobel Prize. The paper uses the secondary car market only as a simple example, and alludes to many other cases of the Lemon effect at work, including health care, or how to counter it (fast food chains). It's a short and great read.

Mon, 20 Feb 2012 • permalink