Information assymetry

In his excellent book The Undercover Economist, author Tim Harford discusses (among many other topics) the problem of information asymmetry, first identified by Nobel prize winner George Akerlof in 1970.

Information asymmetry
Information asymmetry is a market condition where the sellers of a certain good know more about the product than the buyers. Akerlof’s example was the second hand car market where sellers know the foibles of their cars but buyers cannot tell the good cars from the bad. Buyers therefore compensate for this uncertainty by offering a price lower than the sellers of good cars are prepared to accept, preventing the sellers of good cars from entering their car in the market at all. Ultimately the effect of information asymmetry is that the second hand car market becomes a market for lemons.

Solution #1 – Experts
Given the value to both sellers and buyers in reducing uncertainty, a variety of businesses have been created to solve the state of asymmetric information in a number of markets. Two examples might be pre-purchase vehicle inspections in the second hand car market and building & pest inspections in real estate. Of course, experts sometimes have different incentives to that of their clients – real estate agents, for instance, have little incentive to get the best price for their clients, instead looking for turn houses over as fast as possible. Freakonomics discusses one study which found that real estate agents kept their own houses on sale ten days longer (waiting for a better offer) than the average, getting 3% more than the price they obtain for you and I.

Solution # 2 – The internet
Of course, the most powerful antidote for information asymmetry has been the internet. Information is no longer controlled by the powers that be – it’s now democratised and readily searchable through Google. It’s also changed the speed at which information is available so that everyone gets it at the same time. Finally, a large number of comparison services have been created to deal specifically with this issue, be it a restaurant guide or customer reviews on Amazon & eBay.

Solution #3 – Other signals of quality
Where information asymmetry persists in spite of experts and the internet, Tim Harford explains that consumers look to other signals for quality that have nothing to do with the product itself. A car dealer with a marble-floored showroom would therefore be viewed more favourably than someone who operates from their garage. This is because their larger investment suggests they are more interested in protecting that investment than doing a dodgy deal and leaving town. I see two problems with this, however, where significant financial investment is involved:

a) Apparent risk only
Investing in non-product quality signals speaks to apparent risk rather than real risk – the marble flooring makes no actual difference to the quality of the BMW parked on it. Being an inefficient solution it may worsen the problem – sellers may seek to recover their investment by massively inflating prices, selling lower cost goods or hitting you with hidden costs.

b) The past, not the future
The second problem with this high-investment solution (such as a showroom) is that it’s an indication of a previous commitment, rather than a future commitment. That prior commitment might also involve high levels of debt, requiring solid-looking businesses to close without warning.

What does all this mean? It’s hard to get people to trust vendors in faulty markets. For you and I who want to sell things, this is a serious problem. In a future post I’ll discuss an inexpensive solution that any business can employ.