German economist and Nobel Prize winner George Akerlof published a paper known as The Market for Lemons in 1970, where he discusses a phenomenon resulting from information asymmetries in the used car market. In this paper, he refers to poor-quality cars as “lemons” after the American slang, and to high-quality vehicles as “peaches.” His main idea states that certain potential purchases can motivate customers to do some due diligence before putting their hands in their pockets. “There are many markets in which buyers use some market statistic to judge the quality of prospective purchases,” he writes.
This means that most of the time, consumers are willing to pay a fixed price for a vehicle that usually amounts to the price average between a lemon and a peach. For instance, if a customer were looking at two different vehicles, the price he or she would be willing to pay could be expressed in the following way:
Sellers know that peaches are harder to sell because most customers are not willing to pay the added cost to their pre-existing price assessment
Price of Peaches > Price Average
They also know that they can maximize their profit by selling only lemons
Price of Lemons < Price Average
The problem resulting from this kind of behavior in the long run is that once sellers of peaches are left with unsold high-quality cars, they’ll be forced to either leave the market or go out of business. Applying this theory to the whole auto industry, companies would need to shift production to low-quality vehicles to remain competitive. What can be concluded from Akerlof’s studies is that ultimately, quality is determined by a market’s prices, or as he would put it: “Bad cars drive out the good because they sell at the same price as good cars.”
HURDLES TO INFORMATION GATHERING
But does that mean the used-car market would thrive on an ignorant population? Not necessarily. The lifespan and performance of many car components, making up for the overall quality of a vehicle, is closely linked to an owner’s driving style, accident history and maintenance checks. Since many of these parts are often located inside the car’s engine, it may be difficult for an unwary purchaser to truly evaluate the state and quality of the car at a glance. To keep track of the status of its national car fleet, the US implemented the registration system for the Vehicle Identification Number, VIN. This unique number compiles crucial information such as the manufacturing location, brand, engine, size, model, and serial number. By running a VIN check, users are given a vehicle’s accident history, number of previous owners or product recalls.
Unfortunately, there are no similar systems in Mexico, but this does not mean the issue is not being addressed. In an interview with Mexico Automotive Review 2017, Edgar Pacheco, Sales Subdirector of the Commercial Division at Honda de México said he believes Honda’s main area of opportunity is in data management. “We have the original owners’ information for the entire Honda vehicle park but cars change hands over the years and there is no public record that tracks the used-car market,” he said.
KEEPING THE MARKET INFORMED
Information asymmetries can impact an industry’s whole market, but there are practices consumers, sellers and policymakers can implement to fight back against the effects of information gaps. According to an analysis from The Economist, there are ways in which sellers of good cars can prove the veracity of quality claims to consumers. Investopedia proposes many solutions to overcome information asymmetries. As usual, technology has become a key enabler for the implementation of such solutions. According Carlos López de Nava, Director General of Grupo Alden, “69 percent of the used-vehicle market exists online.” As the role of online retail platforms grows bigger, the measures to keep lemons out of the market become more important. Some of these include:
- Consumer Protection Regulation – In an attempt to protect consumers, the Mexican law established the trade requirements and guidelines for used-car sales. This regulation holds the previous owner liable if the purchased vehicle were to malfunction.
- Guarantees – Provide protection to the consumer and establish the seller as a reputable and reliable provider. In an interview with Mexico Automotive Review 2017, Ignacio Caride, Director General of MercadoLibre México, mentioned that certified programs have been crucial in boosting sales through online platforms because they give clients confidence regarding the functionality of the vehicle and the warranties clients can claim.
- Standards – These are the minimum requirements sellers and products must meet for a used vehicle to be accepted into retail. Miguel Plazas, Sales, Product and Marketing Director of GM Financial de México, says the group’s dealer network is increasing used-vehicle sales, fueled by its certified used-vehicle program.
Akerlof’s study, The Market for Lemons, was published in a time when naïve customers were prone to make purchase decisions based the information they received from the only available source: the car dealer’s words. Today, the likelihood of customers being misled by a seller has decreased as a result of the widespread access to the internet. Experts agree that the fact that online retailers have taken the initiative to gather, store and provide information on a car’s history has played an important role in stopping lemons from taking over the market. José Gómez, CEO of Grupo Gocar, a dealership group that buys and sells new and used cars, believes modern society’s ability to access information at the touch of a button has revolutionized the car industry. In the words of Gómez, “Today, the internet has underpinned the fast development of the used car market, providing the business with transparency, agility and reliability.”