Entrepreneurial Solutions to Adverse Selection Problems

|Peter Boettke|

A new working paper is out by my colleagues at Mercatus -- "How the Internet, the Sharing Economy, and Reputational Feedback Mechanisms Solve the 'Lemons Problem.'"  The lead author Adam Thierer has been doing some great work at Mercatus on entrepreneurship and public policy, and his Mercatus book is must reading for all who are interested in the vitality of economic life -- Permissionless Innovation.

In the early 2000s, I actually work with one of our PhD students -- Mark Steckbeck -- on the topic of how reputational feedback mechanisms were emerging in e-commerce to address adverse selection problems.  Our paper "Turning Lemons into Lemonade" was published in 2004 and focused on the reputational feedbacks on E-Bay by way of a case study of the sale prices of high end photography equipment.

But what is most striking about all of this when you study it closely is two things -- even Akerloff's original paper, he actually implies the solution to the "lemons problem" at the end of the paper, but the popular understanding of the literature is that this was a market failure that required a government solution, and in 1940s Hayek had already pointed out the critical importance of reputation in dynamic market competition in his essay "The Meaning of Competition".  As Hayek wrote:

In actual life the fact that our inadequate knowledge of the available commodities or services is made up for by our experience with the persons or firms supplying them — that competition is in a large measure competition for reputation or good will — is one of the most important facts which enables us to solve our daily problems.

 

Comments

[msreekan]

Private institutions like Amazon, Google, Yelp etc all improve information accessibility. They are all about solving the Hayekian systemic problem -- "of rapid adaptation to changes in the particular circumstances of time and place"

[Charles N. Steele]

Excellent points. Also relevant: Yoram Barzel's "Some fallacies in the interpretation of information costs," JLE Oct '77

[liberty]

I absolutely agree with the examples set out here, but although reputation is a force that can be and is harnessed to keep firms and sellers in line in many markets, unfortunately as of today it is not enough to stop many, especially large and powerful, corporations from engaging in highly unethical behaviour. If we can find a way to better harness this force - petitions help, but we still need more - then markets will themselves have a far better reputation.