01 October 2019

New CEBI working paper featured in the Economist

A lemon is rotting from the inside, i.e. it looks nice on the surface even if it is not good. In his 1970 paper, “The market for lemons”, Nobel laureate George Akerlof shows how trade will be limited in markets where sellers know more than buyers. In his context, a lemon is not a fruit but a car which looks great on the surface but is actually defect.

Akerlof showed that when there is asymmetric information about the quality of cars, then people with high quality cars are reluctant to sell their car. Buyers anticipate this and offer a lower price. That discourages sellers even further and prices spiral down until it is impossible to sell good cars at a price which matches its quality. Akerlofs example was extreme. In reality, not all used cars are lemons.

In a new CEBI working paper “Durables and Lemons: Private Information and the Market for Cars”, by Richard Blundell,  Ran Gu, Soren Leth-Petersen, Hamish Low and Costas Meghir, analyze car prices and administrative data on income and car ownership in Denmark.

They do this to understand the extent to which lemons really are a problem. They find that the lemons penalty varies strongly with ownership duration. For cars put on the market after having been owned for only one year, the lemons penalty is as big as 18%, and it is 8% for cars which has been owned two years when they are put on the market. The lemons penalty becomes smaller as car ownership duration increases further.

A new car put on the market thus might raise suspicion, because it may be a car of relatively low quality. This might explain the phenomenon that cars lose a lot of value at the moment where they are sold.

Read the article in the Economist

Read the CEBI working paper