What Prevents Electronic Lemon Markets?

Abstract

It is well known that the “lemon” problem can cause market failure. Because difficulties in quality discovery of nonstandardized and complex products will increase transaction costs, it was predicted that the “electronic market” would prevail only with less complex and more standardized goods. However, it has been observed that there are many successful electronic (auction) markets for seemingly typical “lemon” goods such as used cars, raw minerals, and agricultural products. It is argued that in such markets, the equilibrium price of electronic trading appeared higher than in the nonelectronic market. Many speculative explanations have been offered for this, but to the best of our knowledge, no analytical studies have been presented. This study is an attempt to fill this gap. In this paper, we look at the problem of quality discovery in the electronic trading of physical goods especially when the goods are not standardized. The information asymmetry between buyer and seller creates the possibility of a “lemon” in the nonstandardized market. To mitigate this problem, several auction markets have devised third party quality grading systems and limited auctions to only relatively higher quality products. Through analytical modeling, we rationalize these mechanisms; that is, the intervention of an impartial third party for quality inspection, market segmentation by quality measure, and the sellers' willingness to pay the cost of quality inspection.