Continuing with his blog series, Ruby Star Associate’s researcher Anthony continues looking at some research studies about business growth in more depth…
In an article by George Akerlof (1970) he describes that there are many markets in which buyers use a market statistic to judge the quality of prospective purchases. In some cases there is an incentive for sellers to market poor quality merchandise. This is especially so when there is an imbalance of information known by seller and buyer (asymmetrical information).
Akerlof mentions one key area in asymmetrical information: the adverse selection model. In this model, the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction. One example of this is when people who are high risk are more likely to buy insurance. The insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual’s risk but also sometimes by force of law or other constraints.
In a sales environment goods can be sold honestly or dishonestly; quality may be represented, or it may be misrepresented. As a buyer, the problem is trying to identify quality in the market. Not having the same information as seller can often put the buyer at a disadvantage. The presence of people in the market who are willing to offer inferior goods can end up driving the market out of existence. The presence of businesses selling inferior goods as standard can drive out legitimate business. This is because many people not willing to risk getting ripped off will avoid certain types of purchases, or not spend as much for a given item
Buying a new or used car is a perfect example of this issue. People looking to buy a car do so not knowing whether the car they buy will be of good or bad quality. Buyers know that the car they buy has a probability of being good quality (x) and a probability that it is of bad quality (y). The imbalance of information between buyer and seller, where the seller knows more about the car than than the buyer. After owning the car for some time, the buyer has a more accurate idea of the car’s quality. This estimate is now obviously more accurate than their initial one and closer to the seller’s knowledge of the car. However, good and bad cars will still sell at a similar price and in similar quantities, since it is difficult for buyers to tell the difference until they become owners.
In the case of used cars; most of them traded in will be of lesser quality, and good cars may not be traded at all. In the same way as new, bad cars drive out the good ones because they sell at the same price. The demand for used cars depends mainly on two variables: the price and the average quality of used cars traded. The supply will depend on the price of each car. Since the supply will always equal demand, as the price falls, so too will the quality.
Retailers can apply certain methods to counteract this problem. If a credible guarantee exists before purchase – that the seller is committed to refunding the buyer in full if a problem occurs in the two years – the problem of different information known between seller and buyer (asymmetrical information) can be solved partly.
In addition to guarantees where the seller takes the totality of the risk and reassures the buyer, brand names are also used to counter the effect of quality uncertainty. The buyer’s trust in a brand ensures him a certain base-level quality of a product. Chains of restaurants, hotels, etc. are seen by Akerlof as also having the same effect. Finally, licenses allow a reduction in the uncertainty of quality, as the example of doctors and solicitors (with medical/legal licenses) can show. A licensing practice, such as a GP surgery, ensures “buyers” a certain level of proficiency.
The imbalance of information known by buyer and seller (asymmetrical information) can contribute to the customer uncertainty of product quality.
The presence of people in the market who wish to sell poor products as good can drive out legitimate businesses.
By sellers taking more of the risk from buyers, guarantees can help counteract the uncertainty of product quality.
The conclusion is that “trust” is very important and that institutions can lead to a reduction of the uncertainty in transactions between buyers and sellers. If guarantees offered are insufficient, business can suffer from this uncertainty.
Based on Akerlof, G. A. (1970). The Market for “Lemons”: Quality Uncertainty and the Market Mechanism
Posted by Rachel Warhurst