The Undercover Economist

Chapter 5 introduces the concept of “inside information,” which is another stumbling block that prevents the ideal of a perfect competitive market from being realized. When one party has inside information the other party doesn’t, it leads to market inefficiency. This idea relates to the work of an economist named George Akerlof, who showed through his research that this problem could be both “profound and dramatic” (116).

To explain this problem, Akerlof used the example of a used car lot where the seller has information about the cars and buyers do not. If half the cars are “peaches” or reliable cars, and half are “lemons” or unreliable cars, then the buyer is in a bad spot. To a buyer, the peach is worth more to them than it is to the seller; otherwise, they wouldn’t be having the exchange. However, there’s a 50% chance that the good car that they’re willing to buy is actually a worthless car that they aren’t willing to buy. A buyer who is sure they’re getting a peach might offer $5,000, but a buyer who is gambling would offer a lower price, like $2,500. However, it’s not a gamble to the seller, who knows whether the car is a peach or a lemon.