I have been researching crowdfunding and the means by which to provide refunds to the crowdfunding community for 3 months now. Crowdfunding markets wouldn’t need refunds if backers had a much better way of gauging if the claims made by various crowdfunding projects were true or not. Because there isn’t a good universally accepted way to predict if a crowdfunding project will fail, backers have to decide if they will pledge to support a project when the balance of information favors the project creator. This turns out to be a very common problem in Economics and Economist George Akerlof even won a Nobel prize in 2001 for having written about it.
Professor Akerlof described a situation in his paper where information asymmetry could lead to market failure. Since most of my audience will not have been familiar with this paper I think it is important to present full quotes from the paper which give the reader a sense as to what he is trying to say (emphasis mine). Before you read the quotes from the paper why not watch a short 3 minute video which explains the topic really well so you can understand the quotes in their context.
For most cars traded will be the “lemons,” and good cars may not be traded at all. The “bad” cars tend to drive out the good (in much the same way that bad money drives out the good) But the analogy with Gresham’s law is not quite complete: bad cars drive out the good because they sell at the same price as good can; similarly, bad money drives out good because the exchange rate is even. But the bad cars sell at the same price as good cars since it is impossible for a buyer to tell the difference between a good and a bad car (see note below); only the seller knows.
It has been seen that the good cars may be driven out of the
market by the lemons. But in a more continuous case with different
grades of goods, even worse pathologies can exist. For it is quite
possible to have the bad driving out the not-so-bad driving out the
medium driving out the not-so-good driving out the good in such
a sequence of events that no market exists at all.
As the price falls, normally the quality will also fall. And it is quite possible that no goods will be traded at any price level.
The presence of people in the market who are willing to
offer inferior goods tends to drive the market out of existence -as
in the case of our automobile “lemons.” It is this possibility that
represents the major costs of dishonesty -for dishonest dealings
tend to drive honest dealings out of the market. There may be
potential buyers of good quality products and there may be potential
sellers of such products in the appropriate price range;
however, the presence of people who wish to pawn bad wares as
good wares tends to drive out the legitimate business. The cost of
dishonesty, therefore, lies not only in the amount by which the
purchaser is cheated; the cost also must include the loss incurred
from driving legitimate business out of existence.
The takeaway is that lemon markets can fail if lemons are so abundant they drive out all the good products. This aspect of information asymmetry causing market failure is not tangential to his paper but rather it should help us to identify these markets. Strangely enough this Nobel prize winning paper only seems to offer up anecdotal evidence at best to support these claims. I expected to find a modern example where a market actually failed because of information asymmetry. I found many markets with high information asymmetry but none that had failed. Maybe I didn’t look hard enough or maybe I didn’t know what to look for.
There has been some critical reception of professor Akerlof’s analogy simply because used car markets don’t fail. The Wikipedia entry describes such criticism as “stemming from literalism, and the inability to see that the car market is being used as an analogy for all markets with asymmetric information.” This seems fine except that Akerlof never provides any concrete historical evidence that a lemon market has ever driven itself out of existence.
If you at this point are saying to yourself “so what, who cares” I’d like to point out that according to the Wikipedia entry
Today, the paper is one of the most-cited papers in modern economic theory and most downloaded economic journal paper of all time in RePEC (more than 8,530 citations in academic papers as of May 2011)
So this paper, regarded as so important as to be one of the most-cited papers in modern economic theory, may be describing something that doesn’t even really exist. But you may be saying Akerlof won a Nobel prize and Joshua Davis is an idiot. Yes I see your point however my argument for why there are no lemon markets is really simple:
- Not every customer within a market has the same set of standards i.e. all people don’t uniformly measure quality in the same way.
- What is a lemon to some people will be acceptable to others.
- Since there is a wide range of participants within a market with a wide range of standards markets with lemons should never fail.
- If markets with lemons never fail they cannot be lemon markets since “inferior goods tends to drive the market out of existence” and we never see that happening.
If the lemon market hypothesis is true then we should be able to find some actual lemon markets which have failed. I feel like its akin to looking for a very rare Pokemon or something.
Information asymmetry present on crowdfunding platforms is greater than information asymmetry in the used car market for a number of reasons but it can be neatly summed up by the following image:
Customer churn rate (customer turnover) as demonstrated in the above data set is more than 66%. This is incredibly high. Even MLMs with questionable reputations may not see this level of churn. Herbalife has a churn rate of 44% and they are about average for their industry. This illustrates that many people are left with a sour taste in their mouth after using Kickstarter and decide not to return but this doesn’t cause the market to fail.
Since there are dozens of smaller crowdfunding markets soliciting projects and funds I expected that at least some of the smaller crowdfunding sites would have gone out of business after some notable failures. I personally never found any well published information to support this hypothesis but it might be true and I welcome anyone to provide evidence that might demonstrate even one crowdfunding marketplace failed due to loss of confidence in the platform by backers. If someone can demonstrate that this happened I will gladly update this post.
Now to back up my claims I have my own anecdotal evidence which is about as compelling as the anecdotal claims given in professor Akerlof’s paper:
So the above two examples are products that I feel are probably pretty bad and likely you feel are bad but someone out there thinks they are good. And in the case of the Ampy 33% gave it 4 stars or above. When you consider your experience if you are like me you never buy products with below a 3.5 star rating for this exact reason. Amazon’s ratings system tends to give products more credit than I probably would because my standards are higher than the average Amazon shopper.
In closing I’d like to leave you with today’s moment of Zen
Thanks for reading my first Medium post.
NOTE: “it is impossible for a buyer to tell the difference between a good and a bad car”
Dear Professor Akerlof,
I believe this is hyperbole what do you think? Is it really ‘impossible’ for a buyer to make this sort of distinction given a number of different factors:
1. A friend who is knowledgeable in such matters can assist the buyer.
2. The reputation of the car lot in question precedes the sale.
3. The buyers ability to take a car to his mechanic to perform an inspection before the sale is finalized.
Anyways hyperbole is really beneath someone who was given the Nobel prize so you should probably fix this in your paper.