If you own a club and have a bouncer at the front door, people who don’t have invites will try to find ways to fool the bouncer and sneak in.
And this problem isn’t just relevant to clubs, but is valid anywhere a selection criteria is in place.
Economist George Akerlof, in his 1970 Nobel-winning research paper, calls this 'The Market for Lemons' and demonstrates the concept using a used-car dealer’s example.
Let’s break it down:
- The used-car dealer has either a quality car, a ‘peach’, or a faulty car, a ‘lemon’.
- The consumer has a fixed budget to purchase a car, which is usually in between the cost of a ‘peach’ and a ‘lemon'.
- From the dealer’s perspective, they know that used cars differ in quality. And they know if the car they’re selling is a peach or a lemon. So they will try to sell the lemon over the peach as lemons are harder to sell later on.
- As a result of many customers being sold lemons a.k.a. faulty cars, consumer expectations in the used-car market fall. Now, consumers expect low quality and cheaper cars.
- However, at the same time, the sellers of ‘peaches’, or high-quality second-hand cars are pushed out of the market, because the consumer is now skeptical and unwilling to pay the right price for a peach. As a result, only ‘lemons’ are left behind.
In Economics, the lemons problem is also known as “Adverse Selection.”
Lemons in insurance
Have you been puzzled by the steep rise in health insurance premiums?
You aren’t alone.
Unhealthy people game the insurance vetting system to get policies and pile up hospitalisation claims. Then the insurer realises they don’t have funds to keep paying, so premiums go up. You cannot afford the policy anymore. Who suffers? The company and you, the fit policyholder.
The risky ones buying medical insurance know that they’ll claim. But the insurer doesn’t.
A prime example is a smoker who successfully manages to obtain insurance coverage as a nonsmoker.
The smoker knows that insurance premiums are lower for non-smokers and is able to successfully hide information about his/her smoking habits from the buyer — the insurance company.
Lemons in edtech
You’ve heard of Income Share Agreements, right? A model where you get to study for free in exchange for a share of your future income. This was doomed to fail because the ‘lemons’ problem crept in.
The not-so serious students saw this as a gateway for freebies because they weren’t interested in a better job anyway. The good ones weren’t keen to part with their salaries so they still chose the loan route. In the end, institutes were stuck with lemons.
Now all of this happens because a few people are constantly gaming the system. One person has more information than the rest. So they take advantage of this information asymmetry.
Lemons in online communities
Remember Clubhouse? It was a lot of fun initially where everyone from Naval Ravikant, Marc Andreessen, Ashton Kutcher, Elon Musk, Keith Rabois, Oprah Winfrey, etc. were on it, having meaningful conversations.
The quality of people using the platform made getting access to it a highly desirable thing.
Now, people who had nothing much to bring to the table wanted to get in due to the perks of being associated with such a reputed community.
Once these folks got in, the quality of conversations dipped. Slowly, the original community members found themselves stuck in boring conversations and dropped out. Now, quality conversations are a rarity on Clubhouse.
This was another case where the platform was left with lemons, only because a few took full advantage of the missing checks and balances.
Lemons in hiring
Companies advertise for fancy qualifications which are tough to find. Knowing pretty well that this is a tough entry barrier, some candidates fudge their CVs and get in.
For the HR manager it's awkward to fire these hires because this is a blemish on their reputation. And it is the case of ‘lemons’ all over again.
Essentially, whenever there is a strict selection or entry criterion of any kind, there will be bad actors who will try to game the criterion.
This, in turn, makes the market worse for the good actors.
Solutions to the lemons problem
- Never explicitly spell out your entry criteria, or selection becomes very easy to game.
- If you make your entry criteria explicit, say in the case of CAT, SAT, or JEE-like examinations, make sure the system is foolproof and impervious to hacks.