How hidden information creates a market for lemons

HostI was looking at a used car online last night. It looked great in the photos, but I kept thinking, why is this person selling it? If it's such a great car, why do they want to get rid of it? It feels like you're always wondering if you're just buying someone else's headache.

HostWhy is it so hard to just find a fair price for a decent used car without feeling like you're getting tricked?

GuestWell, it comes down to a simple, annoying fact. The person selling the car knows way more about it than you do. They know if the engine makes a weird sound on cold mornings or if the transmission slips once every ten miles. You just see a shiny hood and a clean seat. Because you can't tell a good car from a bad one, you're not willing to pay top dollar. You're worried you might be buying a lemon. So you offer a middle of the road price to play it safe. But that middle price is a huge problem for the people selling the really good cars. If you have a car that you have treated like a baby, you know it's worth ten thousand dollars. But if buyers are only offering seven thousand because they're scared of getting a dud, you just won't sell it. You would rather keep the car or sell it to a cousin.

HostWait, how's offering an average price a problem? If I offer a fair average, shouldn't that work out for everyone in the long run?

GuestYou would think so, but look at it from the seller's side. If the buyers are only offering an average price, the people with the best cars leave the market. They take their toys and go home because they feel cheated. That leaves only the people with the okay cars and the people with the lemons. Once the best cars are gone, the average quality of the cars left on the lot drops. Buyers aren't dumb. They notice this. They realize their odds of getting a lemon just went way up. So, what do they do? They lower their offer even more. Now, the people with the okay cars—the ones that are fine but not perfect—they feel like the price is too low for them, too. So they leave. In the end, the only cars left are the true lemons. The market basically eats itself because of that gap in what people know.

HostThat feels a bit dramatic. I mean, can't a seller just tell me the car is good? We have words. They can show me receipts or just look me in the eye and say it has been taken care of.

GuestTalk is cheap, though. A guy selling a lemon will say the exact same thing as the guy selling a gem. In fact, the guy with the lemon has a bigger reason to lie to you. He wants to trick you into paying that higher price so he can get rid of his problem. Unless the seller can prove it in a way that's impossible to fake, their words don't really add much value. This is the heart of the hidden facts problem. It's not just that I don't know the car is bad. It's that I can't trust you when you tell me it's good.

HostSo it's not that buyers are being cheap, it's that they're being smart about the risk they're taking.

GuestYeah, and it acts like a tax on the whole system. Everyone loses. The buyer can't find a good car, and the person with a good car can't find a buyer willing to pay what it's worth. This shows up in places you might not expect, too. Think about health insurance. If an insurance company offers a plan, who's most likely to sign up first? It's the people who know they're sick. The healthy people look at the price and think it's too high for them since they rarely go to the doctor, so they stay away. That leaves the insurance company with only the sickest people, which forces them to raise prices even more. It's the same downward spiral.

HostBut we have things like history reports now, right? And mechanics who can check the car out before I buy it. Doesn't that bridge the gap?

GuestIt helps, but it's never perfect. A report only shows what was reported to a shop or the police. If I hit a pole and fix it in my garage with some duct tape and spray paint, no report will ever know. And a mechanic can spend an hour with a car, but they haven't lived with it for three years. They might miss the fact that the heater stops working after forty minutes of driving or that the oil leaks only when the car is tilted on a hill. The gap in what people know stays there. That's why we see things like big warranties. A seller who offers a three year warranty is putting their money where their mouth is. A guy with a lemon can't afford to do that.

HostOkay, but what if the car is just old? Like, if I'm buying a twenty year old truck, I expect some issues. Does the lemon logic still apply when everyone knows the thing is a bit of a wreck?

GuestActually, it matters even more then. With an old truck, there's a huge difference between one that was loved and one that was beaten up. But if they both look rusty on the outside, the buyer will offer the same low price for both. The owner who loved his truck and changed the oil every month won't sell for that low price. So the only old trucks you find for sale are the ones that were beaten up. The hidden facts make the good old stuff almost impossible to find on the open market. You end up only seeing the junk.

HostIt sounds like trust is actually the thing being traded, not just the metal and the tires.

GuestThe truth is what's missing, so the only cars left are the ones that nobody else wanted to keep.

HostThose shiny cars on the lot start to look a lot different when you realize the best ones might never have made it there in the first place.