Adverse Selection & Watch Collecting

From Lemons to Luxury: How Economic Theory Shapes the Watch Market

Have you ever wondered why something that seems too good to be true, usually is? Often, this is due to a concept called adverse selection. Simply speaking, adverse selection happens when people make choices based on what they know, but others don’t. Let’s talk about it!

Estimated reading time: ~16 minutes

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Understanding the Market for Lemons

Adverse selection originated in the insurance industry, and was first described by economist George Akerlof in his 1970 paper, “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Akerlof used the example of used cars to illustrate how asymmetric information can lead to market failure.

According to Akerlof, because sellers know more about the quality of their cars than buyers, buyers will assume all used cars are of average quality and will therefore only be willing to pay an average price. This drives high-quality cars out of the market, leaving only “lemons” behind. Incidentally, Akerlof’s paper is how the general concept of describing a bad selection as a “lemon” was born!

Say you’re looking to buy a used car. You know there are good cars (let’s call them “peaches”) and not-so-good cars (“lemons”) out there – except you can’t quite tell which is which. We’ll use this chart to cover the basics:

Initial Market Conditions:

• The supply curve (S) represents all cars in the market, both good (“peaches”) and bad (“lemons”).

• The demand curve (D1) represents buyers’ willingness to pay, assuming all cars are of average quality.

• The intersection of S and D1 gives us the initial equilibrium price (P1) and quantity (Q1).

Information Asymmetry:

• Sellers know whether their car is a peach or a lemon.

• Buyers can’t distinguish between peaches and lemons, so they’re willing to pay an average price (P1).

Effect on Sellers:

• At price P1, lemon sellers are happy because they’re getting more than their cars are worth.

• Peach sellers are dissatisfied because they’re getting less than their cars are worth.

Market Adjustment:

• Over time, some peach sellers decide it’s not worth selling at P1 and withdraw from the market.

• This leaves a higher proportion of lemons in the market.

Buyers’ Response:

• Buyers realise the quality of cars in the market has decreased.

• As a result, they adjust their expectations downward, shifting the demand curve from D1 to D.

New Equilibrium:

• The new intersection of S and D gives us a lower price (P) and quantity (Q).

• At this lower price P, even more peach sellers withdraw from the market.

Continuing Cycle:

• This process continues, potentially leading to a market dominated by lemons.

• The quantity of cars traded decreases from Q1 to Q as the market deteriorates.

In the extreme case, the market could completely collapse, with no cars being traded - This is what economists call a “market failure.” The market isn’t working efficiently because sellers know more than buyers. As a result, good products (peaches) get pushed out by not-so-good ones (lemons), and everybody loses out: buyers can’t find good cars, and sellers of good cars can’t get fair prices. I suppose, generally, this demonstrates why trust and reputation are so important in markets where quality is hard to judge before buying.

General Intro to Adverse Selection

The concept of adverse selection has since been applied to many fields, including healthcare, lending, and even online dating. In healthcare, for example, people who know they are sick are more likely to buy health insurance, which drives up premiums for everyone. In lending, people who are least likely to repay a loan are often the most eager to borrow, and this leads to higher interest rates.

In dating terms, the most window-dressed profiles promise more than they can deliver. This mismatch in expectations tends to discourage genuinely good matches from staying on the platform, leaving the market flooded with less desirable singles. As the high-quality matches leave the platform, the remaining ones are more likely to be matches which lead to failed relationships.

Modern economic theory builds on this concept of adverse selection. In 2001, economists George Akerlof, Michael Spence, and Joseph Stiglitz were awarded the Nobel Prize in Economics for their work on asymmetric information and adverse selection. They showed how adverse selection can lead to inefficient outcomes and how various mechanisms, such as signalling and screening, can be used to mitigate its effects. In fact, Tinder offering a $500 subscription fee for Tinder Select tier is a funny but accurate example of identifying and trying to solve this adverse selection problem. Despite being aimed at less than 1% of its user base, it is essentially designed to cater to the most active (and presumably high-quality) potential matches.

How does adverse selection apply to watch collecting?

As a watch collector, you’re often dealing with asymmetric information. The seller of a watch almost always knows more about its condition and history than the buyer. This can lead to adverse selection, where the watches being put up for sale are more likely to have problems that are not apparent to the buyer.

Let’s run through a couple of basic examples to explain the point.