Consider a market for used cars where half of the sellers have “bad” used cars on offer (let’s call them lemons), with the rest being plums. (You know you’re back in college when you begin sentences with ‘consider a…”!) The “bad” sellers are willing to let their lemons go for Rs. 1000, and the “good” plums are being offered for Rs. 2000. Now, the buyers in the market know that half of the cars on sale are lemons, but there’s no way of telling which one. The price they’d be willing to pay, then, would be the weighted average of lemons and plums:

(fraction of plums) x (price of plums) + (fraction of lemons) x (price of lemons). In this case, this would be Rs. 1500. This is great news for the lemon-sellers, but is terrible for the plum-sellers – it makes it infeasible for them to sell their plums anymore. The prescence of lemons, therefore, drives some plum-sellers out of the market. This drives prices down even further, eventually leading to an all-lemon market – and the market itself collapses. Fascinating, eh?

So why don’t markets around us collapse, left, right and center? It’s because of the principle of “signalling” – some point of difference between the “good” plum-seller and the “bad” lemon-seller. So what can a plum-seller do? If he competes on price, he risks being labelled a lemon. What he can do, is to offer some sort of proof based on the fact that his is a superior product, and therefore justifies the higher price. Something that becomes inpossible for the lemon-seller to do. In the used-car market, this is usually a one- or two-year guarantee. This is difficult for the lemon-seller to match, since his advantage is based on information asymmetry. (The whole lemon and plum theory falls within the domain of information asymmetry). That’s how most markets function.

Which brings me to the idea of “stamped email”. A few years ago, when much of the world was struggling to beat spam – those unsolicited emails that used to invade your inbox (and still do, if you aren’t using good old Gmail), there was a real fear that email itself would become unfeasible to use because of the sheer volume of spam. We have better spam filters today, but those were fearful days!

The difference between email and plain old post is that the sender doesnt’ have to pay a thing to send one, one hundred or one thousand emails. So some bright soul came up with the idea of “stamped email” – in other words, the sender would pay a small amount while sending the email. The email, in turn, would bear a virtual “stamp”. Think about it – if you found a letter in your postbox that didn’t have a stamp on it, it’d probably be spam, dropped into the box directly. The idea was to implement the same for email.

Now see the parallel? Your mail server without a spam filter is a victim of information asymmetry. It can’t tell between legitimate email and spam. The virtual stamp is the “signal” – that assures the mail server that the email has been sent by a non-spammer, i.e, one who’s borne the monetary cost of sending that email. Of course, what happened eventually was that our spam filters got so good, we didn’t need to resort to this anyway – inspite of the fact that even today, significantly more spam is sent over the Internet than legitimate email.

You can see the lemon and plum principle in operation everywhere around you. For instance, think of the market for mobile phones. Your dealer will offer the same model in “gray” for a discount – but without the bill and associated warranty. The warranty is the “signal” to the buyer indicating the phone is a genuine “plum”.

Can you, dear reader, suggest more examples of the lemon and plum principle with signalling from everyday life?