It’s the Lemons, Stupid: Economic theory, Scamville and why everyone should know better
[caption id=”attachment_288" align=”alignright” width=”279" caption=”You can’t make lemonade with this kind of Lemon”]
Michael Arrington recently called out Offerpal and the like in his series of Scamville posts the most recent of which suggests a class action lawsuit may be in the works. This series is a great example of journalism and it focused our attention on a doomed market before the failure occurred, however, his focus on the end consumer as the victim only tells half the story.
The inevitable failure of this market and the companies that profit from it should have been obvious from the initial business plans — and not only because consumers would get fed up and stop signing up for offers but because the existence of dishonesty in the market will drive out the legitimate businesses. As an entrepreneur, understanding your ability to differentiate your service and the quality of your good from those of your un-ethical competition could be the difference between success and failure.
Here is why:
The economist George Akerlof wrote a paper in 1970 called “The Market for Lemons: Quality Uncertainty and the Market Mechanism” that describes the fundamental problem with the business model of Offerpal et al. In the paper Akerlof explains the inevitable “no trade” equilibrium in a market where:
a) Inferior goods exist
b) Buyers cannot determine the quality of the item prior to purchase
For Zynga and the other social gaming sites, the consumer lead is the good being traded and the value of each lead is dependent on the average revenue it brings to the buyer. They should know better than to head down this slippery slope and they should know the problem is the Lemons. (see Wikipedia for more here)
-Assume a market with 100 total leads where all leads are known to be the same to both the buyer and the seller and all leads generate marginally more than $10 to the buyer. This total market of 100 leads will clear at an average price of about $10 creating a total market of $1,000.
[caption id=”attachment_290" align=”alignleft” width=”300" caption=”Hate them becuase they ruin markets…”]
-Now assume that some number of leads (for simplicity let’s say 50) are actually worth $0 in revenue to the buyer and that there is no way to tell the difference between a $0 lead and a $10 lead. If the buyer realizes that there is a 50/50 chance of getting a $10 lead and a $0 lead, the price they are willing to pay drops to the average value of the lead or $5–100 leads are still traded, but this shrinks the total market from $1,000 to $500.
-As the average price drops from $10 to $5, sellers with leads that are actually worth $10, with no ability to signal this value to the buyer, are forced to exit the market or sell their leads for less than they are worth.
-Over time, as sellers exit the market, the average price of a lead will continue to fall forcing more and more sellers to pull out. In the end, this process leaves 50 leads all worth $0 and a market in equilibrium with no value and nothing traded.
Akerlof warns us that “The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”
The market for leads created by the OfferPals of the world fits this description exactly and if Zynga and others who monetize through offers (or profit from the advertising Zynga buys) want to stay in business, they should read Akerlof’s article and clean up their markets before they reach the point of “no trade.” It is the right thing to do for the consumer, but it is also the only thing to do for the business.