On Lemons and Marketplaces

Almost half a century ago, a young assistant professor of Economics from UC Berkeley landed in Delhi to spend a year doing research at the Indian Statistical Institute. His work over the next 18 months led to results that were, in hindsight, as obvious as they were profound. His name was George A. Akerlof, and over three decades later, he won the Nobel Prize in Economics for his resulting paper, “The Market for Lemons.” How is that relevant for us in 2016? Turns out, this research provides an interesting lens with which to view online marketplaces in India.

In his seminal paper, Prof Akerlof describes how markets operating in the absence of quality information can lead to a cascading series of events that drives out good actors, leaving behind only bad actors selling poor quality goods (aka the Lemons). Here’s one simplified explanation of his work. Consider a marketplace of used cars, where sellers Sally and Sarah are selling the same model of used car to buyer Bob. Sally has a high quality car, the fair market value for which is $6000. Sarah has a car with a defective engine, one that she knows will fail in the next few years. The fair market value for her vehicle is $2000. Bob, however, is not privy to any such information — as far as he is concerned, both sellers are trying to sell the same product, although there’s a chance that one or both of them have a lemon.

In this market, Bob is willing to pay somewhere between the fair market value of a good car ($6000) and a lemon ($2000) to buy his vehicle. Let’s say he thinks that there’s a 50–50 chance he could land up with a bad car. Being a smart man who understands expected values and probabilities, Bob decides that a fair price for him to pay for the car is halfway between $6000 and $2000 — i.e. $4000. In these kinds of markets, sellers of good products (like Sally) are not getting as much as they should, and sellers of poor products (like Sarah) are getting more than they should. Prof Akerlof proves how this information asymmetry creates a market dynamic and economic incentives that over time drives out the good actors and keeps only bad actors. Eventually, the market is full of lemons — the good sellers have decided that this is just not worth their time, and buyers cannot access high quality products.

Sounds familiar? Chances are you’ve seen such dynamics in many forms. One example that is relevant in our world of technology are online classifieds. In the absence of information, we often see such platforms filled with people selling low quality goods. Over time, we see these places filled with spam, bait-and-switch sellers, and overpriced and / or defective products, and legitimate sellers are drowned out in the noise. As a result, we often hear people talk about online India being “low on trust”. Online classifieds are trying to address this by focusing on a few specific verticals, but in the absence of trust, this problem is inevitable. (FIX)

Using our framework above, we can now better understand why this happens, and more importantly, how we can fix it — by addressing the asymmetry in information that plagues many marketplaces. In the used cars world, this has been addressed with certifications and warranties. In horizontal e-commerce marketplaces, merchant ratings and reviews, combined with more standardized pricing, addresses these problems. Consumer to consumer marketplaces, such as horizontal classifieds, however, have no such mechanisms built in. The seller rarely has ratings. There are often no standardized prices. And most products are not certified or guaranteed by a third party.

The founders of Zefo, a C2C marketplace for used furniture and appliances, decided to tackle this problem. Instead of minimizing friction in selling, they focused on maximizing trust, by doing everything needed to ensure that sellers could sell conveniently, and buyers could buy knowing that they were buying a high quality product. They decided the right model for their customers involves picking up products from sellers so they get paid a fair price immediately, certifying the quality of each item, and selling online to buyers who can trust the quality of the merchandize they are buying. Even though it’s a C2C marketplace, this approach sidesteps many of the trust pitfalls that plague other platforms, and leads to an interesting business model that is in many ways unique to India. By heavily investing in backend technology, and a careful selection of addressable categories, they were able to scale quickly and profitably, all while getting an extraordinary amount of buyer and seller love.

We often talk about how smart founders are contrarian, thinking first principles while focusing on user delight over everything else, and building solutions that are unique to their markets and not simply clones of what works elsewhere. The team at Zefo fits that description perfectly, and their strong growth (40% monthly), terrific customer love (NPS > 60) and margin structure is a testament to that. Today we are excited to announce that Sequoia India has led a series A investment in the company. After all, it’s hard to argue with a company who’s raison d’être previously led to someone winning the Nobel Prize.