Information and markets, 1

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market.

--The Market for Lemons: Quality Uncertainty and the Market Mechanism, George Akerloff. (1970)

Markets that don't have a good way to judge the quality of the goods being sold have a problem. As Akerloff noted, if buyers can not differentiate quality, they will pay for a statistically likely quality level. This will then drive away the higher quality goods (thus lowering the statistically likely quality level!) Buyers then adjust their price down, and this downward cycle continues until only the shoddiest goods are left.

One long-standing problem in the lead-gen industry (and, in a different way, in the display ad industry) is the inability to grade quality. There are high-quality leads and low-quality leads (quality here meaning likelihood to convert into a sale.) It's cheap to generate low-quality leads (think reg path or, if you've been around a few years, free ipod.) It's expensive to generate high-quality leads.

Problem is, once a lead is generated, it's pretty hard to tell if it's high quality or low quality. You can cross check address, telephone number and email, but you can't see from the face of the lead the key unknown: intentionality. Does the lead actually intend to buy the good or service they entered their information for. Anybody who's been the person calling the lead can tell you how often they hear "I'm not interested in a new car, I just wanted the free _____." This is a poor quality lead, despite all of the information being correct.

Imagine a lead market where the leads have a random quality from 1 to 100. Leads with quality 1 are worth $1. Leads with quality $100 are worth $100. What would you pay for a lead? Statistically it would make sense to pay about $50. On average, you would be getting your money's worth. But when the price level is $50, the people who are selling the leads with quality greater than 50 all leave the market (and, probably, start generating lower quality, lower cost leads.) The average quality now sinks to 25, so the price also goes to $25. Repeat until the quality reaches the lowest increment. This is Akerloff's point, and what I've seen actually happen in lead marketplaces.

Now, ask yourself, why is the inventory trading through the ad exchanges the worst inventory above remnant? Buying and selling through an ad exchange beats direct buying and selling in every single way that doesn't involve expense account meals. Yet both direct sales and ad network/rep sales have higher CPMs than the ad exchanges, because buyers believe the higher quality impressions are sold that way. Is there an information problem here?