In his post on “Lemon Market, Baby Milk and the Government“, edc29 talks about the existence of lemon markets for packaged baby milk in Indonesia. This phenomenon can be seen in light of a more general phenomenon which states that lemon markets are more likely to exist in underdeveloped economies which do not have adequate legislation to protect the interests of the buyer. In this blog post, I will highlight a few examples of “Lemon” markets that existed in the past in developing economies in the absence of structured corporations and proper legislation to protect the interest of the buyers. My examples will also highlight the crucial role that can be played by information in countering these “Lemon” markets.

John McMillan, in his paper on Market Institutions, talks about the existence of a lemon market for cow milk in India in the 1970’s. During that time, the milk market in India was not structured and basically consisted of a large number of individual milkman who sold their milk directly to consumers. [Contrast this to developed economies where there exist huge corporations that sell branded milk in the market and guarantee the purity of the milk] Some milkmen watered down their milk down before selling it to consumers as this made them more profit. Since, the consumers had no way to measure the butterfat content, they were unwilling to pay the real price of unadulterated milk. Thus, the honest milkman were left with no incentive to sell pure milk as they were unable to fetch the price of pure milk in the market. In this way, the market for milk was reduced to a market for “Lemons”, where only watered milk was put up for sale. In order to counter this phenomenon, the National Dairy Development Board established local “cooperatives” and armed them with inexpensive devices to measure the purity of milk. This narrowed the information gap between the buyers and the sellers and the buyers were able to price the milk to reflect its measured quality.

McMillan also highlights a different and very interesting “Lemon” market for credit in Bangladesh. Banks had no real way to track the credit worthiness of poor farmers in the absence of a unified mechanism to record credit history of an individual. Furthermore, there was little or no legislation to prosecute defaulters. Under such circumstances, the banks found it hard to distinguish good borrowers (those who will pay back) from “Lemons”, who would default. Furthermore, the borrowers after having secured the loans had little incentive to pay back. To counter this issue, the Grameen Bank of Bangladesh started lending to groups of borrowers instead of lending to individuals. The group of borrowers were generally the neighbors of the prime borrower and came in close contact to the prime borrower on a day-to-day basis. Hence, this group was in much better position to evaluate the individual’s credit worthiness than the bank officials and could invoke social sanctions (in the absence of formal legislation) in case the individual defaulted. Also, as the banks held the whole group responsible for the loan, the rate of loan recovery went up. In this way, the bank was able to avoid “Lemons” by resorting to group lending.

The Market for “Lemons”: Quality Uncertainty and the Market Mechanism