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The Market for Lemons

It's high time that the government took steps to reform the Indian real estate sector, which is marred by lack of transparency

The idea for this column essentially came from a friend who has been trying to buy a house for his parents for a while now. Before I discuss my friend's experience in detail, let me explain something known as the 'market for lemons'.

This theory was put forward by the economist George Akerlof (now better known as Ms Janet Yellen) in a 1970 research paper, titled 'The Market for "Lemons": Quality Uncertainty and the Market Mechanism'. In this paper Akerlof talked about four kinds of cars. As he wrote: "There are new cars and used cars. There are good cars and bad cars (which in America are known as "lemons"). A new car may be a good car or a lemon, and of course the same is true of used cars."

When an individual buys a new car, he does not know whether the car he is buying will turn out to be good or a lemon. Nevertheless, over a period of time, the car owner does figure out whether he has bought a good car or a lemon. Hence, an information asymmetry develops. As Akerlof put it: "After owning a specific car, however, for a length of time, the car owner can form a good idea of the quality of this machine...An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers."

And this creates a problem. The lemons and good cars sell at the same price. "The bad cars sell at the same price as good cars since it is impossible for a buyer to tell the difference between a good and a bad car; only the seller knows," wrote Akerlof.

What this meant was that a seller of a good used car will not get the right price for it simply because there was no way a buyer could figure out whether the car was a good car or a lemon. And this even led people to buy new cars instead of an old car.

In an essay titled 'Writing the "The Market for 'Lemons'", Akerlof wrote: "I knew that a major reason as to why people preferred to purchase new cars rather than used cars was their suspicion of the motives of the sellers of used cars."

Long story short, a buyer would not buy without proof and the seller did not have the proof. And this led to the market for second-hand cars not working well. Tim Harford explains this phenomenon very well in his book The Undercover Economist. As he writes: "Anyone who has ever tried to buy a second-hand car will appreciate that Akerlof was on to something. The market doesn't work nearly as well as it should; second-hand cards tend to be cheap and of poor quality. Sellers with good cars want to hold out for a good price, but because they cannot prove that a good car is really a peach, they cannot get that price and prefer to keep the car for themselves. You might expect that the sellers would benefit from inside information, but in fact there are no winners: smart buyers simply don't show up to play a rigged game."

Information asymmetry essentially ensured that the market did not work at all. And this was primarily because one side of this transaction had much more information than the other side.

As Nate Silver writes in The Signal and the Noise: The Art and the Science of Prediction, "In a market plagued by asymmetries of information, the quality of goods will decrease and the market will be dominated by crooked sellers and gullible and desperate buyers."

This gets me back to my friend who has been trying to buy a house for his parents for a while now. The real estate market in India is plagued by huge information asymmetry, where one side (i.e. the broker and the builder) has all the information. And this has led to a situation where buyers are gullible as well as desperate.

My friend first started looking for a home online. It took him some time to realise that his chances of dealing with a buyer directly were low and in most cases he ended up dealing with brokers. That being the case, he decided to start dealing with brokers directly.

This did not help either. There was no way of reliably figuring out what the prevailing price trend in any given locality was. All brokers he went to told him that prices were on their way up. But how was that possible given that the flats they went to see were in buildings which were largely empty? This obviously meant that transactions were not happening. And even if they were happening the volumes were simply not there. The buyers have no way of figuring out whether deals are actually happening or not and hence need to either believe the broker or play mind games with him.

As Jeff Madrick writes in Seven Bad Ideas: How Mainstream Economists Have Damaged America and the World: "Almost all homebuyers...enter into such transactions only two or three times in their lives. How can they possibly be knowledgeable and informed?"

This nexus between brokers and builders needs to be broken down if the home-buying experience has to improve and the information asymmetry is to be whittled away. This can happen if bigger institutional brokers enter the market. They will then start thinking about the buyers as well. Currently, brokers work at an individual level and are only interested in keeping the builders happy.

The government can also help by aggregating the stamp duty data from across the country. This data can then be sliced and diced city-wise and within that area-wise as well. The number of transactions being registered will give us some idea of what the demand situation is. This data needs to be widely publicised.

Further, efforts need to be made to collect as much data about the real estate sector as possible. Currently, that is not happening. Only if these steps are taken can the real estate buyer be empowered over a period of time.

Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected]

This column appeared in the February 2015 Issue of Mutual Fund Insight.