Why the Average Price Buys the Lemons.

What he was looking at

Akerlof used the used-car lot as what he called a “finger exercise”: a small, familiar market to show a general idea. The seller knows whether a car is a good one or a lemon. The buyer can’t tell them apart, so the buyer knows only what cars like it are worth on average, and pays accordingly.

Then he took the same logic to health insurance for people over 65, the hiring of minorities, the cost of dishonesty, and credit markets in developing countries.

What he found

If the buyer will only pay the average, the price is too low for anyone selling a good car. So they keep their cars. That lowers the average quality of what’s left on the lot, which lowers what buyers will pay, which drives out the next-best cars.

“For most cars traded will be the “lemons,” and good cars may not be traded at all.” Akerlof (1970), p. 489

The market doesn’t just get worse. It shrinks: “there tends to be a reduction in the average quality of goods and also in the size of the market” (p. 488). In the extreme case, “no market exists at all” (p. 490). And he didn’t think this was a curiosity of car lots:

“the difficulty of distinguishing good quality from bad is inherent in the business world” p. 500

The paper was hard to place. In Akerlof’s own account, two journals rejected it as too trivial, and referees at a third argued that “if this paper was correct, economics would be different.” The Quarterly Journal of Economics took it. In 2001 Akerlof shared the Nobel prize in economics with Michael Spence and Joseph Stiglitz for their analyses of markets with asymmetric information.

What it means

Nobody behaves badly in Akerlof’s market. The good sellers leave because the price can’t tell them apart from the bad ones. Economists call it adverse selection: one price for everyone selects for the worst of what’s on offer.

Where it shows up in a revenue team

Turn the story around and put your business in the buyer’s seat. Every marketing dollar buys customers, and the customer knows far more about what kind of customer they’ll be than you do. At the moment of the sale, a customer who’ll be worth ten times the average and one who’ll barely pay back look the same.

• One target for every lead. A single cost-per-lead or cost-per-acquisition target pays the same for a great customer and a poor one, then buys wherever they come cheapest.
• Offers that widen the door. No money down, a free month, a deep first discount: each brings in more of the customers who needed the door widened.
• The way out is the same in his market and ours: a signal that tells good from bad before the price is set. That’s where Spence picked up the story three years later.