Would you buy a used car from this economist?
It was in the latest edition of that distinguished scientific journal Car & Driver that I first saw mention of Nobel Laureate George Akerlof's seminal 1970 article, "The Market for Lemons". I'll come up with a real estate angle to this, but it'll take a few paragraphs.
Akerlof's learned-to-the-point-of-being-unreadable article (I found a PDF online) is another example of science turning its lofty gaze on something us jus'-plain-folks can relate to and presumably profit from, since it uses the example of lemon cars to pioneer the now-widely cited theory of asymmetrical information: the idea that one party to a transaction, invariably the seller, knows more about the good being sold than the other party, invariably the poor sucker buyer. (I say "invariably" because Wikipedia's entry claims that asymmetrical information always benefits the seller, although stories of $500,000 paintings going for $5 at garage sales seem to refute this.)
According to Akerlof, poor sucker buyer adapts to this information imbalance by assuming that all cars, whether lemons or well-maintained "cherries", are of only average quality, and therefore will pay only the average price for any used car, lemon or cherry. This penalizes owners of cherries, who refuse to sell, lowering the quality of the pool of used cars offered for sale, which further penalizes sellers of better used cars, which further reduces the quality of the pool, etc. etc. to the point where eventually (time frame not specified) all that's left is crap (not necessarily the word Akerlof uses). Which is news to all of us happily driving clean late-model used cars.
Akerlof's theory struck me like a thunderbolt, not only because I'd just bought a used car—George, where were you when I needed you?—and not only because of its wildly improbable outcome (the end of all markets for used goods, which is news to eBay and Goodwill), seemingly the hallmark of trend-setting economic thought, and not only because I'm willing to bet that Akerlof got most of his astonishing insight into the used-car marketplace when as an impecunious grad student back in 19-and-59 he pedaled to Charlie's Cheapies and plunked down $50 for a clunker that lost first gear five minutes after he gunned it off the lot, but also because—and here's the real estate angle—it reminded me of something equally unreadable and improbable I'd seen buried deep on pages 19 and 20 of the S&P/Case-Shiller Home Price Indices Methodology.
As you no doubt know, Case-Shiller grinds out the most quoted home price indices in the country, to the point where you'd be excused for thinking they're the only home price indices in the country, but what isn't often quoted (or even read by the people who breathlessly quote Case-Shiller, since it would only make their heads hurt) is its methodology. Methodology, according to Merriam-Webster, is "a body of methods, rules and postulates employed by a discipline; a particular procedure or set of procedures". It's the quality of the methodology that separates intelligent scientific research from the foolish, naive, wild-eyed stuff, although since there doesn't seem to be a "soft science" theory out there that could ever be proved or disproved in the cold hard light of the real world, I'm still not sure how the consumer of economic theory can tell the difference.
Okay, now I remember: if you agree with it, it's pure scientific gold. If you don't, it isn't. Nothing could be more objective.
The idea that buyers of any used good don't and can't know what they're getting into seems implied in these sentences from the Case-Shiller methodology, which explain why its creators feel the need to fiddle with the data:
It is also assumed that the two sale prices that make up the sale pair are imprecise, because of mispricing decisions made by homebuyers and sellers at the time of a transaction. Mispricing variance occurs because buyers and sellers have imperfect information about the value of a property. Housing is a completely heterogeneous product whose value is determined by hundreds of factors...The difficulty in assigning value to each of these attributes, especially when buyers and sellers may not have complete information about each factor, means that there is significant variation in sale prices, even for homes that appear to be very similar.
Translation: buyers and sellers don't know what the heck they're doing out there in the resale market, but economists do.
Translation: economists don't know what the heck buyers and sellers are doing out there in the resale market, but a few changes to the algorithm—and a few aspersions cast in the general direction of buyers and sellers—will solve that little problem.
But at least Akerlof's theory of
asymmetrical information gives consumers credit for being rational animals—if
the marketplace penalizes you, you don't enter the marketplace. But giving
credit where credit is due isn't popular these days among economists
studying the inexplicable behavior of that unguided missile, the consumer.
And even Akerlof has had a change of heart, according to some
distinguished-looking gent I found on the Internet, Robert Skidelsky, Emeritus
Professor of Political Economy at the University of Warwick, "politician,
writer, prize-
I wonder: does this make "The Market for Lemons" a lemon?
It's interesting to note that back in 1970 "Market" didn't exactly hit the economic community like a thunderbolt, at least not initially. Wikipedia says that "both the American Economic Review and The Review of Economic Studies rejected the paper for 'triviality', while the reviewers for Journal of Political Economy rejected it as incorrect, arguing that if the paper was correct, then no goods could be traded. Only on the 4th attempt did the paper get published." Even today, "economic literature is divided on whether a lemons market actually exists in used vehicles".
But it's science, cited more than 7,730 times in academic papers as of July 2010! It must be true!
But enough of alleged flip-flops and what passes for bedrock truth in economics. Here's what we're here to find out: can Akerlof's theory of asymmetrical information be applied to the resale housing ("used houses") market? Does one party, invariably the seller, know more about the condition of the house than the other, invariably the buyer?
Certainly this would make a great centerpiece for any homebuyers-are-suckers post on the Internet, but like most such posts, it doesn't stand the light of day. You'd be surprised at how little most homeowners know about the condition of their own home, at least before they have their own inspections done. You might also be surprised at how often the buyer's inspections find things the seller's inspections didn't. And you'd definitely be surprised at how often sellers over-estimate the market value of their own home, and how often (unsuccessful) buyers under-estimate it. There's plenty of information shortfall to go around, not limited to either side, although I'd say that, at least in this area, where buyer due diligence has risen to an art form, and where "disclose disclose disclose" has almost replaced "location location location", buyer and seller are evenly matched.
Which I guess is why we still have a market for used homes here.
Or there might be other reasons. I'll have to review the literature and get back to you on that.