The Internet: Turning Lemons into Lemonade

Used car dealers get a bad rap. Sure, they have enshrined themselves in our society by their cheesy commercials, their sometimes sleazy business deals and, not to mince words, the often shoddy cars they offer for sale. But really, that’s not the fault of the car dealers—it’s human nature. A quirk of behavioral economics—the lemons problem, to be exact.What’s a lemon, precisely? It’s a car you can’t distinguish by just looking at it. It’s the type of car that seems great on a test drive—and then, as soon as you sign the title, breaks down on I-94 at midnight. As famously described by Nobel Prize–winning economist George Akerlof in 1970, the problem with lemons is that they sour the entire market. Since a consumer can’t tell a lemon just from seeing it—or even after taking it for a preliminary spin—it means he can’t know whether he’s purchasing a clunker or a “plum” car. This, in turn, drives down the prices for all used cars, which then causes sellers of plums not to put their cars up for sale through the muddied channels. Before you know it, used-car prices are low, but that’s just because there are only lemons on the market. Hence, the “lemons problem” that once upon a time confounded consumers and seemed, in most markets, intractable.Intractable, that is, before the Internet came along. The Internet has made the lemons problem less, well, problematic. Where you once had to rely on good word of mouth and old-fashioned intuition, there’s now a bevvy of information at your fingertips.

In some regards, you may expect the Internet to exacerbate the lemons problem. With no barriers to entry, anyone can put any product or used good up for sale. And they do. There are countless scams, from down payments on cars that never arrive to counterfeit or duplicate sports tickets. A new vocabulary even emerged to describe lemons on the online-dating market: catfishing, something Manti Te’o is familiar with.

But just as the Internet seemed to be evolving into one massive, global market for lemons (see the early iterations of Craigslist), it introduced and enabled the solution: reputations markets. Consumer reviews, like those common on Amazon and Etsy, let other potential buyers know upfront whether the seller is offering a legitimate product, based on past behavior and reputability of the seller. There’s also increased price transparency, as services like Kelley Blue Book, TrueCar, Cars.com and more publish detailed local and regional data on product-specific pricing. Finally, people offering top-rate legitimate used products have learned to use clever signals—like the willingness to post some personal information online—to verify their companies’ and products’ legitimacy. The information asymmetry that once existed on these markets is being eliminated as consumers are let in on what sellers know.

Actually, recent research indicates that some e-commerce markets may even have the potential to reverse the lemons problem completely. Sellers with bad marks from buyers don’t survive on the competitive e-commerce market, causing them to drop out. Of course, capitalism being what it is, a new market has emerged to help those sellers with negative online press: reputation fixers who flood review websites with five-star praise. These services have the potential to dilute the power of online reviews, making it possible for lemons to re-enter the market.

The Internet may not have completely solved the lemons problem, but what interests me is that it has enabled a level of transparency that changes the construct of a historical riddle of commerce and human nature. One economic problem solved, but the fun is just starting, as the Internet has created an entirely new set of economic conundrums. But then again, that’s what entrepreneurs are for—to solve new economic riddles through capitalism and ingenuity.

This post was originally published on LinkedIn on March 7, 2014.

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