ICOs and Economics of Lemon Markets

Market for Lemons

Market for Lemons

What would happen if buyers of a particular product couldn’t tell the difference between good and bad quality products? It would be fair to assume that sellers would try and push their products as good quality in order to maximise their returns. In this case of information asymmetry only sellers know the real quality of their products. We can then assume that uninformed or unsophisticated buyers will begin acting on overall market sentiment where the quality of the products are expected to be somewhere between the good and bad quality products i.e. there is uncertainty in product quality. What effect does this have on the market for a product? This is exactly the phenomenon explored by economist George Akerlof in his seminal paper published in 1970, ‘The Market for Lemons: Quality Uncertainty and the Market Mechanism’ [1], for which he jointly received the Nobel Prize.

  • In American slang a “lemon” is a car that is found to be defective after it is bought.
  • Suppose buyers cannot distinguish between a good quality car and a lemon, therefore they are only willing to pay a fixed price for a car that averages their value i.e. prices will be between good quality cars and lemons.
  • Sellers know whether they hold a good quality car or a lemon i.e. they have more information than buyers, but there is no way for buyers to know whom to trust.
  • As buyers will only buy at a fixed average price, given quality uncertainty, means sellers will only sell when they hold “lemons” since the price of a lemon is less than the average sale price.
  • On the other hand, the fixed average selling price means that sellers will leave the market when they hold a good quality car, as the average sale price is less than the true value of the car they have for sale.
  • Eventually, as enough sellers of good quality cars leave the market, the average sale price for cars will decrease as quality deteriorates.
  • As the quality continually deteriorates eventually sellers of average quality cars will also exit, leading to further reduction in the average selling prices.
  • This continual lowering of the average sale price and resulting deterioration of quality leads to a downward cycle until the no-trade equilibrium is reached i.e. buyers cease to buy as they will expect only lemons.
  • Thus asymmetric information and the challenge of uninformed buyers making decisions based on general market sentiment rather than individual informed views results in the Adverse Selection Problem, driving good quality cars from the market and potentially leading to a market collapse.

“Banks wanted to offload toxic assets. But they had better information than the market did about how toxic their assets were. The markets therefore discounted heavily what the banks offered for sale, so heavily that the Banks didn’t offer good quality assets for sale. But knowing this, and not wanting to buy worthless assets, the markets withdrew.”

Conditions for a Lemon Market

Akerlof’s simple but effective model of the impacts of information asymmetry on a market can be broken down to a number of conditions that can potentially lead to a lemon market:

  1. Information Asymmetry: buyers cannot accurately assess the value of a product through examination before a sale but sellers can.
  2. Skewed Incentives: An incentive exists for sellers to pass off low-quality product as higher quality.
  3. Lack of Disclosure Framework: Sellers have no credible disclosure mechanism, so good quality is difficult to differentiate from low quality.
  4. Low Quality or High Variation: There is a high variation of seller qualities or the average seller type is sufficiently low quality.
  5. Lack of Assurance: There is a lack of quality assurance either through reputation, guarantees, regulations or other clear legal protections.

Trust in a Lemon Market

The interesting thing about Akerlof’s work is that he didn’t just leave us with a problem and no way of preventing or minimizing it. A key part of his work is the importance of trust for market stability. While he touched on how informal unwritten quality guarantees can be preconditions for trade and production, such as reputation and brand recognition, he also pointed to how formal licensing/regulations and other clarity around legal protection can help reduce uncertainty [4]. In this case there would be no adverse selection problem because an asset’s fundamental value would be known with some level of certainty.

From Lemons to Bubbles

While Akerlof showed that in the extreme case a market subject to the adverse selection problem, resulting from information asymmetry, can lead to market collapse, such market “implosions” are not common, and something subtler takes place.

“as an asset’s market price falls to a sufficiently low level, the potential value from buying the asset increases to a sufficiently high level to attract non-experts to purchase the asset — in spite of the risk of getting stuck with a lemon. Therefore, rather than a market collapse, assets in such markets can often sell for less than their fundamental value.”

The key conclusion of Emery’s work is that while adverse selection can lead to a market collapse this is not always so, in reality a “negative bubble” is more likely, where buyers can pick-up bargains. However, Emery extends this to show that a mirror image of negative bubbles can occur under certain conditions, where assets can start trading above their fundamental value — leading to positive bubbles. A condition that is more prevalent in markets compared to negative bubbles.

Market Dynamics Based on Return and Horizon Preferences

Beware the ICO Lemons

Our foray into market dynamics and stability shows us that conditions that lead to lemon market scenarios may result in market collapse or more likely a negative bubble, but if such conditions are accompanied with positively skewed market sentiment e.g. rising asset values, a positive bubble can ensue where buyers chase dreams.

  • Perceived Zero Accountability: Issuing companies currently have a sense of zero accountability for claims made during an ICO process. This is supported by detailed disclaimers and small print.
  • Limited Ongoing Responsibilities: In many cases an ICO is structured to appear as an “open source infrastructure layer” and the financial contributions are deemed to be donations made to an abstract “non-profit” co-operative, even though an incorporated company may be used to deliver key solutions. As such the ongoing value of issued tokens is considered to be unconnected with the efforts of the delivering organisation or the team members linked to the ICO, and the ongoing performance is considered as a community responsibility.
  • Minimal Cost and Complexity: There is a minimal upfront cost and complexity to execute an ICO, with biggest cost being time to build up a community following and draft a white paper. Driving a community following can also be accelerated at minimal cost by leveraging social media influencers who feel there is very little accountability and or reputational impact on them if things go wrong.
  • Minimal Technical Requirements: Due to lack of requirements for a minimal viable product and or detailed technical specifications, technical barriers to entry are only limited to convincing and recruiting advisors and claims of future hires with key skills. In many cases key technical contributors are sought who provide “reputation as collateral” [8] to legitimize the offering and signal to consumers the capabilities behind the ICO.
  • Scarcity and Liquidity: Implementing a monetary policy that is based on token scarcity and with a liquid secondary market, combined with implied claims for demand of tokens for access to future products, there is a perception the issued tokens could increase in value in the short term and early buyers can sell out. This drives a fear of missing out (FOMO), and hence higher initial demand for the ICO digital token.
  • Perceptions of Growth: The industry currently has a positively skewed perception of the ICO phenomenon and cryptocurrency in general. While there is a growing sentiment that the market is reaching a peak, at which point either regulators will step in or buyers will start exiting due to over inflated prices for subpar tokens, there is still a view that short term token investors can make a quick gain and pass on their holdings to unwitting long term investors on a liquid secondary market before the bubble pops.

So is it a Lemon?

If we have a crowd that is socially influenced, a market that suffers from skewed asymmetric information and little or no controls or assurances we will likely see assets trading outside of the bounds of their fundamental value. In such cases it is highly likely a positive bubble will persist until there is some abrupt news that forces “experts” to exit the market, which will leave “non-experts” holding assets at an inflated value. Without previous trading volumes to support the inflated value, asset prices will begin to drop until they are at or below the fundamental value. To some extent this simple mental model was highlighted by Hyman Minsky in his work “The Financial Instability Hypothesis” [9], albeit from a wider economic context where periods of prosperity encourage greater leverage and progressive recklessness, where excess optimism creates financial bubbles and the later busts. He argued that such up and down cycles are endemic and inevitable in a capitalistic economy, which is a type of market failure and requires some form of controls.

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Avtar Sehra

Avtar Sehra

CEO and Product Architect @Nivaura, previously a Financial Engineer and Theoretical Physicist Fascinated with the Group Theory of Rubix Cubes