Crawl Across the Ocean

Monday, March 29, 2010

46. Asymmetrical Information

Note: This post is the forty-sixth in a series. Click here for the full listing of the series.

I should have covered this topic when I was talking more about the commercial syndrome, but better late than never.

Wikipedia offers the following definition for information asymmetry: "In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard."

The classic example of the problems caused by asymmetrical information is the used car market, thanks largely to a famous paper, "The Market for Lemons: Quality Uncertainty and the Market Mechanism (pdf)" published by George Akerlof in 1970.

If the customer is unable to tell a good car from a 'lemon' then the customer will be willing to pay a price that reflects the average value they can expect, given the percentage of lemons on the market. But the seller knows whether a car is a lemon or not, and if it isn't, then the seller knows that the car is worth more than what the customer is willing to offer. So the seller only offers bad cars at the price the customer will pay. But then the customer may become even more unwilling to pay as much, if all they seem to get are lemons. In an extreme case, the market could cease to exist altogether (Akerlof cites life insurance for seniors as a market which doesn't exist for this reason).

The basic structure here is that there is a gap in time between when an exchange is made and when the services are rendered (e.g. you pay for a car up front, but then expect it run for years), and this gap in time, combined with a lack of perfect information for either the buyer or seller, combines to create opportunities for fraud. Commercial folks have invented a wide array of mechanisms to combat this market-busting problem (e.g. warranties, trial periods, etc.) but the strongest bulwark has to be a general trait of honesty in commercial dealings.

Akerlof notes that where this honesty is lacking, economies remain underdeveloped.

When the seller is at the disadvantage (i.e. has less information than the customer), then the seller faces a problem known as 'adverse selection.' If an insurer offers a life insurance policy at a certain rate, then it takes the risk that the only people who will sign up at that rate are those who know that they will profit because their risk of death is higher than average (e.g. smokers, people with pre-existing conditions, bad family histories, etc.). People whose risk of death is lower than average will see the insurance as a bad deal.

Faced with the possibility of adverse selection, it will be in the interests of the insurance companies to all offer a very similar suite of products, as any variation from company to company will just give more options to people looking to choose a policy that will be of net benefit to them. Ideally, everyone would be forced to sign up for a standard insurance option and this would eliminate the risk of adverse selection (see Health Care, Universal).

Note how the motives of competition driven by maximization of individual self-interest become (in some ways) counter-productive in the face of asymmetrical information. Market participants need to pass up opportunities for fraud and dishonesty to help keep the market functioning. And sellers faced by adverse selection need to restrain their commercial instinct to grab market share by offering new or better terms than the competition lest they get saddled with a bag of lemons.

Note: Next Tuesday's post in the series may need to be delayed pending internet access, post-move.

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