Why the Average Price Buys the Lemons

What he was looking at

Picture a used-car lot. The seller knows whether the car is a good one or a lemon. You, the buyer, can’t tell them apart. All you know is what cars like it are worth on average, so that’s what you pay.

Akerlof called the car lot a “finger exercise” and used that small, familiar market to show a much more general idea. 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

So what happens when 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. It’s a snake eating its tail, and it gets worse every round.

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

The market shrinks, too. In Akerlof’s words, “there tends to be a reduction in the average quality of goods and also in the size of the market” (p. 488). Take it far enough and “no market exists at all” (p. 490). And he didn’t think any of this was a quirk of car lots:

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

The paper had a hard time finding a home. By 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 ended up publishing 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

Who’s the bad actor in Akerlof’s market? Nobody. The good sellers leave because the price can’t tell them apart from the bad ones. Economists call that adverse selection. When everyone gets one price, that price selects for the worst of what’s on offer.

Where it shows up in a revenue team

Now turn the story around and put your business in the buyer’s seat. Every marketing dollar you spend buys customers, and each customer knows a lot more about what kind of customer they’ll be than you do. On the day of the sale, the one who’ll be worth ten times the average and the one who’ll barely pay back look exactly the same.

• One target for every lead. A single cost-per-lead or cost-per-acquisition target pays the same for a great customer as for a poor one, and then it buys wherever customers come cheapest.
• Offers that widen the door. No money down, a free month and a deep first discount all bring in more of the customers who needed the door widened.
• The way out is the same on the car lot and in your business. You need a signal that tells good from bad before the price is set. That’s where Spence picked up the story three years later.