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A modern, dynamic, market economy incorporates a variety of trust mechanisms so as to promote high levels of commerce. Shopping at Costco, for example, allows almost no reason for consumers to hesitate to conclude a transaction. Costs are low, quality is high, and you can easily return anything for a full refund. Even the otherwise intimidating stock market provides somewhat similar comforts. If your impressively svelte barber urgently persuades you to buy 100 common shares of nutrition company Herbalife, the trading commission for the purchase will be about $9. You might share your investment decision with an informed friend, and that person might tell you that some billionaire hedge fund manager insists Herbalife’s business model is a Ponzi scheme. There’s no need to panic, though: for another $9 you can sell your Herbalife shares, and whether you changed your mind a day, a week or a month after the fact, the odds are pretty good the stock will still sell for about what you paid for it. You might even read that a different hedge fund manager thinks Herbalife will prove a terrific investment. In the deep trading volumes of the carefully regulated U.S. stock market, no matter how little you may know about what you are buying, you can be confident there’s an expert who agrees with you. If that were not the case, then the stock would not sell at the price you paid; it would cost less.

Would that the same comforts might apply to all of our major purchases, such as in the notorious world of used cars, where buyers live for years with the consequences of decisions nervously made in relative ignorance.

Economists and The Used Car Market

Economists are attracted to the used car market because it serves as a prime example of how people transact amidst informational asymmetry. This is a fancy way of saying that sellers typically know a lot more about the hidden condition of what is on sale than do buyers. In a paper for which he was awarded the Nobel Prize in Economics in 2001, Berkeley professor George Akerlof (the husband of Federal Reserve Chairwoman, Janet Yellen) anticipated that while buyers might be ignorant, they will not be stupid. They know that sellers prefer to sell lemons. Those who need to buy used cars should thus be reluctant to buy used cars, a confounding situation that recalls Groucho Marx’s famous quip that he would not wish to become a member of any club that would have him as a member. Akerlof wrote that the cycle of cynicism might well continue. If all used cars are perceived to be likely lemons, potential buyers will not offer fair value even for the used cars that sellers insist persuasively are of excellent quality. Reductio ad absurdum, those who have good used cars won’t try to sell them because they know they are unlikely to receive fair offers. Only lemons will go up for sale, and this will lead to demands on the part of buyers for ever lower prices. Akerlof noted that the absence of formal or informal quality guarantees imperils the future of markets characterized by irreconcilably asymmetrical information. In a feat of prescience that makes his accessible paper a fresh read today, Akerlof went on to wonder if people inclined to buy health insurance aren’t assumed to be similarly lemon-like by insurance companies. After all, who is most eager to buy health insurance? Not those confident about their future health. Published in 1970, Akerlof’s work remains one of the most commonly cited economic papers.

Akerlof’s worries were at some level acknowledged by California’s Car Buyer’s Bill of Rights, which became a law in 2006. Per the bill, California used car dealers must offer contract cancellation insurance such that buyers may return used car purchases within 2 business days. The option costs about 1% of the price of the used car. In conjunction with title documents that stipulate whether a car has been in a serious accident (as would be indicated by a “salvage” title) and private, web-based services (such as Carfax) that provide seemingly reliable vehicle servicing records, buyers of used cars now have a fighting chance of obtaining good information about a car’s history. Casual observers perceive that such knowledge advantages buyers. As we know from Akerlof’s insight, however, sellers of quality used cars likely benefit from these developments as much as buyers since buyers with greater protections against lemons are far more willing to pay full, fair price.

My own purchase of a used car this summer reinforced this same paradoxical truth. Because I bought a car from an individual on Craigslist and not from a dealer, I had no option to return the car that I purchased. Moreover, because I knew the seller would receive multiple offers for his 2003 Honda –a plodding but popular used car- I had to make a quick decision and without benefit of research. Sure enough, within weeks I had to replace the timing belt (as I expected) and also a defective catalytic convertor, an expensive problem a visit to a skilled mechanic would have uncovered.

Parenthetically, my homely car became for no good reason a source of alternating mirth and ridicule within my household. I note that parking an unattractive, inexpensive car in a sketchy neighborhood makes for an excellent source of family entertainment. Some family members may delight to return from an event to find that such a car has been neither stolen nor vandalized, whereas others may have trouble hiding disappointment. Conversations regarding the accuracy of crime statistics and the urgency of urban renewal are intellectually stimulating.

At the end of the summer, and when the used car was no longer much needed, I was intrigued when a dinner guest expressed his interest in buying my car should I wish to sell it. My heart quickly affirmed Akerlof’s insight, however: since I now knew the car rather well, that it spun like a top and was without defect, why would I sell this “cherry” to someone who might price it as if it were a lemon? I will not sell it.

One wonders if there might be something that applies to used cars and other markets characterized by less than robust disclosure, such as, say, the Chinese stock market. In both markets, relatively inexpensive prices suggest that buyers fear a preponderance of lemons – that if we moved beyond outward appearances we would surely discover the need for costly structural adjustments. Given that the Chinese economy has doubled in size in six years and is as large as that of the U.S. on a purchasing power parity basis, one wonders if Professor Akerlof’s portfolio contains a meaningful allocation to beaten down yet potentially “cherry” Chinese equities that perhaps need little more than the equivalent of a new timing belt. Alternatively, perhaps he prefers to play the seemingly safer game of paying full price for the investment equivalent of a shiny new domestic car. In all likelihood, his wife’s day job probably precludes him from trading at all, but it would be fun to know, nonetheless. As ever, caveat emptor.

Filed under: Financial Planning

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