The expressed concerns of my friends when they heard that I am currently bidding for a business can be summed up as ‘information asymmetry’. Which reminds me of Akerlof’s paper. Which reminds me of prostitution (because they are totally related! With information asymmetry I mean. Not my business. Not at all.) Now I will comment on an industry I have no experience in. How very economist of me.

1. Information Asymmetry

Akerlof’s 1970 paper described a market for used cars with a portion of the products being sold as so called ‘lemons’: cars that look normal but not functional. The sellers know the condition of the cars they sell, but potential customers don’t. A seller can accept a price lower for a lemon than they would for a normal car; a customer is willing to buy normal cars at a price profitable for the seller (potential welfare gain), but not the ‘lemons’. In this setup where the quality of the cars are indistinguishable for the buyers, the market price for both kinds of cars must be the same. However, since this market price is lowered to account for possibility of obtaining a lemon, lemons tend to be traded more easily than normal cars, thanks to the sellers’ lowered reservation price for lemons. With the ‘right’ configuration, no car can be sold because the price customers are willing to pay is too low for normal car sellers. And who would buy a guaranteed lemon?

The collapse of the used car market is clearly suboptimal because we assumed that surplus can be gained from the transfer of normal cars. To revitalize the market, it is often proposed that a third party ‘technician’ be introduced and inspect the cars being sold and provide proofs of quality. In fact, the ‘technician’ doesn’t even have to really inspect the car (shamelessly insert my own paper here): as long as the welfare gain from a normal car transfer is higher than the transfer of a lemon, there exists a fee (or tax) levied on the car that a normal car seller is willing to pay and the lemon owner isn’t. The customers can then find a quality car with certainty simply by demanding proof of fee payment.

A few conclusions can be drawn from this simple model:

1. Even just a portion of bad quality products can collapse the whole market;

2. An quality test or a fee can be used to keep good quality products in circulation;

3. A conclusion seems trivial now but becomes important later, is that the said quality test or fee can also be used to keep bad quality products out of the market.

2. Prostitution

If you ask a random person on the (pre-COVID 19) street what (s)he thinks about the market for prostitution, (s)he will very likely say it’s bad, don’t participate in it. If you then ask why, other than morality reasons (we leave that to sociologists), (s)he will give you a reason much like the above market for lemons: you can’t trust the person you are dealing with. Indeed, it is well known that prostitution spreads disease. And the transaction involves both sides making themselves vulnerable in front of not-very-trustworthy type of people.

But instead of collapsing on its own as our model predicts, prostitution seems to still stand strong all over the world despite most governments banning them. So what gives? 

The explanation that the participants are unaware of the risks involved seems unlikely to me (refer to my random-person-on-the-street comment above). A more plausible explanation is that, unlike our assumptions in the model, the participants still have something to gain even at the current risks of meeting lemons. After all, the sellers probably don’t have better alternatives to generate income, and the buyers may be, I don’t know, desperate?

An outright ban carries the intention of stopping a practice altogether. But effects and intentions are not always the same. In this case in particular, transactions tend to be carried out in private, ban or no ban. So banning probably won’t achieve desirable effect.

Enter the conclusion 3. What if, instead of banning, prostitution is regulated with regular health certificates (inspection) or a tax (fee)? Now healthy market participants can credibly separate themselves from the lemons, allowing them to trade in a legal, safe environment. What’s more interesting is that, after separation, lemons will be identified as such, making participating in the unregulated market even less desirable than it is today. As a consequence, the market for prostitution, which has always existed, will generate more social surplus; the spread of disease and violent crimes can be reduced; the government may even receive a small boost in income. The only losers in this case are the lemons who would otherwise participate in the unregulated market. Now they have to either trade with other known lemons or give up entirely. But that’s the intention of the ban all along! 

P.S A friend of mine mentions that the industry may able to screening itself of lemons without acknowledgement by the government. While I can see how it benefits those involved, a guild-like system in the black market also carries its own inefficiencies, such as the ability for the guild to monopolize (lower quantities and higher price than efficient level) and (possibly) the lack of consequences for the participants to cheat. It’s not like you can sue anyone in a banned industry…