Economics for Accountants (And Entrepreneurs) (Part 3)

In Part I of this post, I explained why the Market for Lemons results in unrealized gains from trade. This means that there are buyers and sellers out there who could both be made better off by trading... But they can't get the deal done. In the specific case of the Market for Lemons, trade fails because the buyer cannot be certain he is dealing with a plum seller.

Here's an important, related notion: Every business plan ever written starts with the observation that there are unrealized gains from trade. This sounds like an outrageously bombastic proposition, but I argue that it is literally true. When VCs and entrepreneurs ask "What's the value proposition?" (which they do), they are really asking about where the unrealized gains from trade are.

If there were no unrealized gains from trade, then you could never start a new business. Why? Because what businesses do is buy inputs (capital, labor, and intermediate goods) from suppliers, convert them into output (think of goods and services), and sell the output to customers. If the trade between suppliers and customers were already perfectly efficient --- in the sense that there was no way to rearrange things to offer both suppliers AND customers a better deal than they've already got --- then you'd never be able to get the new business off the ground.

Unrealized gains from trade can arise in a lot of ways. As one example, consider search costs. Amazon.com's business is built (partly) around reducing search costs, and hence allowing buyers of books and sellers of books to find each other more easily. That is, before Amazon existed, some buyers and sellers were prevented from realizing gains from trade because of the difficulty of finding each other. A buyer who really wanted quite a specific book might not be able to find it at his or her local B. Dalton Bookseller, and hence the trade wouldn't happen. Amazon makes it easy for buyers to find just what they want. Think of all the trades that didn't happen before Amazon existed, and think of Amazon taking a just a small piece of the value in each trade. Those pennies add up.

As we've been discussing, unrealized gains from trade can also arise from informational problems, as in the Market for Lemons. Because there are unrealized gains from trade, there's money to be made from figuring out how to get the trade to happen.

This explains Carmax. It also explains Executive Search Firms (aka headhunters).

If you think about Carmax's business model, they are an intermediary in the used car market. That is, they buy AND sell used cars. And if they're going to make a profit doing that, then there must be some reason why they're able to do better than buyers and sellers would be able to do on their own. That is, at least some sellers have to prefer dealing with Carmax to dealing with buyers directly. And at least some buyers have to prefer dealing with Carmax to dealing with sellers directly.

Let's start on the buyer side. What buyers are afraid about in the Market for Lemons is buying a Lemon car at a Plum price. This is why buyers shy away from cars with plum prices. But what if Carmax is selling a used car at a plum price? Should buyers believe that the car is actually a plum? There's reason to think that Carmax can do a better job (compared to individuals) of committing to sell ONLY plums at plum prices. Carmax can more easily offer warranties. And it can more easily develop a reputation for honest dealing, at least compared to an individual who sells a car once every five years.

On the seller side, in the Market for Lemons the plum sellers can't sell at all, because buyers fear buying a lemon car at a plum price. But suppose Carmax employs skilled mechanics who can, after inspecting a car for a while, do a good job of distinguishing plums from lemons. Then Carmax can be confident that when it pays a plum price it isn't getting a lemon, and plum sellers will be better off selling to Carmax than selling directly to a buyer who is afraid of buying a lemon.

Now, this isn't everything about the Carmax business model, but it's part of their edge. They facilitate trade in the used car market and, like Amazon, take a small chunk.

Headhunters work on much the same principle. The Market for Lemons affects the labor market because no firm wants to pay a plum price only to find they've hired a lemon executive. Headhunter firms connect buyers (firms looking to hire) with sellers (executives looking for new opportunities) and reduce search costs like Amazon. But they also check references and try to develop a reputation for successful placements. This reduces information asymmetry, and is what allows the headhunters to charge high fees.

So, an important point about the Market for Lemons is this: If markets fail to realize gains from trade, then there's a profit opportunity. So firms (and other economic institutions) will try to arise to get that trade to happen. Accounting is one economic response to the Market for Lemons. Entrepreneurship is another.

So entrepreneurs and bean counters have more in common than they think.