According to George A. Akerlof, reputation matters. Take the case of buying a used car from a single seller. Assume there is a 50% chance that the used car will be a lemon and a 50% chance that it will be a peach. If that particular used car would normally sell for $10,000, then a peach might be worth $14,000, and a lemon might be worth only $6,000.
Owners of a peaches know they will lose $4,000 on average when they sell the car; whereas owners of lemons know they will gain $4,000 on average. Therefore, lemon owners are always willing to sell while peach owners are more reticent.
If that is the case, then, on average, more lemons will be sold than peaches. Buyers, instead of having an even chance obtaining peaches, they have a 30% chance. When that happens, the used car price will decline and cause peach sellers to leave the market, resulting in more lemons on the market.
The way out of this dilemma, as explained by George Stigler, is for buyers to engage in more searches to see which ones look good and which ones look bad. The buyer might even carry out inspections, also. But that takes time. Granted, there are a lot of online resources that can help discern a peach from a lemon but sometimes those don’t work. The problem is that the original owner has the inside information on how good or bad the car really is, while the buyer has much less information. What happens is that it takes so much time to purchase a car, the costs of searching for one starts to add up such that eventually buyers become tired of searching; they’ll either gives up entirely or just buy the first car they see.
The other way out of this dilemma is for sellers to build a reputation. Although on the one hand, with a single buyer and a single seller there are not many chances to build a reputation; on the other hand, with a dealer or with a business that takes care of multiple transactions, you can build a reputation. Buying from a reputable dealer may add to the cost of buying a car, but in the end it may well be worth it.
I recall buying a used TV back when I needed an older technology TV that could receive alternative foreign TV signals. One was available on a bulletin board. So, I negotiated for it and bought it from the person. Sure enough it was a lemon. Therefore, I took it to a reputable TV repair person, who fixed it but for about the same price I had paid for the set. Luckily after that, it worked as intended. So, even though I paid twice what I wanted, it still cost less than a new version and worked as intended for several years. Nevertheless, you can’t always tell whether you’re getting a peach or a lemon.
Businesses, however, need to build reputation and keep it. But some businesses may try to cash in on their reputation by selling lemons, or bad services, advertised as peaches in order to make ends meet; this is never a good idea. While the gains of cashing in on one’s reputation may seem tempting, keeping a high reputation is the hallmark of good business, and it will serve you well for years to come through good and bad times.
In the end, having good business relationships, and a good business reputation and building that reputation is important. But wait!
Didn’t all those Wall Street banks cause over extensions with collateralized debt obligations and basically cause the financial crisis? Did they keep their integrity? The answer to that is complex and possibly extends back to the Franklin D. Roosevelt administration; the simple answer: maybe. Even the queen of England asked the London School of Economics what the heck happened, and undoubtedly the answer came back as “a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key,” as Winston Churchill once said.
Integrity, though, is the basis of capitalism, and business integrity is what keeps America strong. And if anything, it is what got us through the financial crisis.
Doug Reynolds is a professor of Economics at the University of Alaska Fairbanks’ School of Management. He can be contacted at firstname.lastname@example.org. This column is brought to you as a public service by the UAF Community and Technical College department of Applied Business and Accounting.