George Akerlof won the Nobel Prize in Economics in 2001 for his research on information asymmetries in markets. His seminal paper on the topic is “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism” and was published in my favorite economics journal – Quarterly Journal of Economics.
So, what’s this paper all about? Well it’s actually pretty easy to understand. First, to be clear, his paper was not actually about lemons, the fruit. Rather, it was a reference to bad used cars (also called lemons). If you grew up reading Matilda, you can think of the cars that Matilda’s dad sold. Those would be lemons. They fall apart as soon as you drive them off the lot.
Rather than used cars, we are going to talk about information asymmetries in the context of bakeries. Imagine you are new to a city, there is no Yelp and you don’t know anyone in town, and you are deciding where to go to get a lemon meringue pie. You have driven by 6 bakeries in your first week in this new town, so you know there are options. The problem is, you don’t know which ones are better than the others. There is information asymmetry. While the bakery owners know the quality of their own pies, you as the buyer don’t have full information about the quality of these bakeries. You don’t know the quality of the ingredients they are using, the skills of their bakers or—most importantly—the overall taste of the pies they sell. Because you don’t have all of this information, you will only be willing to pay an average price for a slice of pie.
Now, If you’re only willing to pay the average price, which places are going to sell pies? The really good bakeries where they use good quality ingredients and hire top tire bakers? Or the not as great ones that cut corners to make pies? Well, lower quality bakeries will be more likely to enter the market than high quality bakeries. Hopefully it is clear that this is not optimal.
So, how do we solve quality uncertainty? Akerlof brings up one possible solution. I’ll copy and paste his paragraph:
One observation consistent with our approach is the chain restaurant. These restaurants, at least in the United States, most often appear on interurban highways. The customers are seldom local. The reason is that these well-known chains offer a better hamburger than the average local restaurant; at the same time, the local customer, who knows his area, can usually choose a place he prefers. (Akerlof 1970, p. 500)
In other words, you know what you are getting when you go into a chain restaurant (or bakery). The quality is pretty consistent, and they often offer the same options. There is reduced information asymmetry.
Yelp and Google Reviews have also helped solve some information asymmetry. If you’re new to a city, and you want to find a lemon meringue pie, the first thing you are going to do is look up reviews for bakeries. If you read a review about the high quality of lemon meringue pie at one particular bakery, you would be willing to pay more for it when you go. The information asymmetry has been reduced! Thanks Yelp!
Some good resources:
Here is a really great video from Marginal Revolution that illustrates the market failure in the lemon car market.
For more fun asymmetry of information examples, I’d recommend “Everything I Ever Needed to Know about Economics I Learned from Online Dating” by Paul Oyer. It is a really fun and funny read with a whole chapter on Asymmetries of Information (that I assign to my students).
Another good article on Akerlof’s research is here.
If you really want to get your nerd on, I recommend reading these economic mystery novels. The main character is an economics professor who uses economic principles to solve crimes. In “A Deadly Indifference” he uses asymmetric information and the market for lemons to figure out who the murder is. That’s all I’ll say for now. But, if you like mystery novels, enjoy!
Two fun facts:
George Akerlof is married to Janet Yellen, former chairwoman of the Fed. Talk about power couple.
I’ve met George Akerlof on two occasions. While I can guarantee he wouldn’t remember me, both times he was incredibly friendly and humble! Hasn’t let the Nobel prize go to his head.
Reducing Information Asymmetries in the Houston Bakery Market
My nephew (who wanted me to make lemon meringue pie so takes full credit for this post - and is also my hand model below) suggested I share some of the best bakeries in Houston – to help reduce some information asymmetry.
Here are his favorites:
Lemon Meringue Pie is my dad’s favorite dessert. And then my brother’s favorite. So, now it is my nephew’s favorite. Coincidence, probably not. We don’t use any fancy ingredients… so maybe we would be considered lemons in the lemon meringue pie world. But, I’m ok with that. We think it’s good.
1 ¼ cup graham cracker crumbs (either break up graham crackers or buy the crumbs)
¼ cup melted butter
¼ cup sugar
1 1/3 cup sweetened condensed milk (1 can)
½ cup lemon juice
1 tsp. grated lemon peel
2 egg yolks
¼ cup sugar
2 egg whites
¼ tsp. cream of tartar
Preheat oven to 325 degrees.
Stir together the pie crust ingredients. Press into pie pan. I then bake in a microwave for 1 minute. Alternatively, you could put in the oven for 8-10 minutes (checking to make sure it doesn’t burn!). Let cool.
Mix together the filling ingredients with a fork.
In a mixer, beat together cream of tartar and egg whites. Beat until soft peaks form. Add sugar and continue to beat until well mixed.
First, pour the filling onto the pie crust. Then add the meringue on top and spread across pie.
Bake pie at 325 degrees for approximately 10 min. or until the meringue just slightly browns on top.
Refrigerate for at least 12 hours. It is best the next day.
The recipe is almost exactly the same as that on the Eagle Brand website but with one less egg.