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All posts by Dan Whalen,
Providence, RI (resume)

Thursday, November 8, 2012

Asymmetric Information

The thing about "the free market" is...

Economists generally like the concept of “the free market” – a reality where all actors are able to arrange their own transactions, on their own terms, and operate to the best of their own abilities. 

It's efficient.  It gives people incentives to pursue what they want, and offers the maximum levels of rewards.  The free market is Wikipedia, command economies are Encarta.  This word simply didn’t exist before, but the phrase “free market economy” in essence signifies a “crowd sourced economy.”

There’s a philosophical defense of the free market as well.  I’m paraphrasing, but the economist Milton Friedman pointed out that when individuals look out for their own personal political/social interest, we view it positively and call it “empowerment.”  But when individuals look out for their personal economic interests, we view it negatively and call it “greed.”  And we shouldn’t.  We really should view both the same – when it comes to advancing your quality of life, a strong economic and political/social position helps immensely.

However, there’s a major caveat here.  The free market doesn’t always work.  In fact, there’s PLENTY of situations where free markets are unable to produce economically efficient outcomes.

Economics professors love to tell students “the free market works best, but only when it works.”  When I did my MA in Economics, “Market Failures” was a required course.

Market failure is any circumstance where all actors are acting unconstrained, and are willing and able to look out for themselves, but still manage to not get what they want, or to waste resources. 

It can be caused by externalities, where a transaction between two parties saddles a third with an unintended cost or benefit.  For example, I make steel, you buy steel, but in the process someone else might get polluted air.  (Externailies can be positive though too.  If I get a flu shot everyone else benefits too -  there's one less person out there you can get the flu from.)

Or it can happen when there are perverse incentives that distort the market.  Think of a government subsidy on corn that encourages farmers to produce more corn then anybody wants or needs.

One of the leading causes of market failure, however, is a little diddy called “asymmetric information.”  Today’s post is about just that.

Asymmetric Information

Asymmetric information is one of economics most prolific monkey-wrenches.  It jacks up the price of health insurance, incentivizes bad film sequels, and makes buying a used car a nerve-racking experience.

What makes it so wide-spread is asymmetric information is a not problem regarding any one particular industry, policy or practice.  It’s a problem with the information surrounding market transactions.  And any market transaction can hinge on information.

The problem goes like this: for the free market to function optimally, buyers have to assess the product they’re about to buy, and decide (for themselves) what price they would truly be willing to pay for the good or service. 

In other words, in the ideal free market, buyers judge goods/services, and offer what they deem to be the “fair price.”  (And remember, the “fair price” we elect to pay IS what something is truly worth – there is no such thing as intrinsic value.  For more on this, see my previous post How are 'prices' determined?)

But what if the buyer knows less about the good/service then the seller does?  How can I decide what I think a good/service is worth, if I there’s something about it I don’t know?

Market for Lemons

In 1970, economist George Akerlof published a highly influential paper called "The Market for Lemons: Quality Uncertainty and the Market Mechanism."  To date, it’s the most concise explanation of asymmetric information and the effect it has on free market operations out there.

The narrative goes like this: picture you’re trying to sell your car.  The car’s in pretty good shape.  You don’t drive it much, and you take good care of it.  You feel it’s worth $5,000, and anyone else who knew the car as you do would think the same.  And you won’t take a penny less for it, since that would feel like leaving money on the table.

Problem is, the buyers don’t know for themselves that the car is in such good shape.  If they drove it as much as you, or had as much history with it as you, they would agree with your valuation.  But they don’t have the same information you have.  They just know that you say it’s a great car – but there’s no way to prove it to them.

So what happens?  The buyer will assume that your car is of average quality, and therefore will offer you average quality car price.  No buyer will offer you $5,000.

If you don’t believe me, picture yourself on the other end.  Imagine you were trying to buy a used car, and are browsing through the classifieds checking them out.  Most cars are going for $3,000, but there’s one going for $5,000. 

The $5,000 car might be twice as good as all the others advertised.  BUT HOW COULD YOU KNOW THAT?

Well you can’t.  The information is asymmetrical.  The seller knows more about the car then you do.

And because the buyers can’t perceive the superior quality that the seller has to offer, and the seller won’t part with the car unless its with someone who recognizes the quality (and therefore is willing to pay the higher price), what happens?  The good cars sit forever in driveways, with “for sale” signs in their windows, and everyone end’s up driving the crappier second hand cars.

When left to its own devises, the free market failed to communicate the value of the item.  As a result, the seller can’t sell, and the buyers wind up driving second rate cars - the “lemons.”

How to correct the problem

Obviously, the solution is to do everything possible to communicate the good value of what you have to sell, so that the buyer knows what’s a good car and what’s a bad one – and pays as such.

This is why used car lots let you take a car for a test drive, or show you the Carfax.  Sellers love that stuff.  Because it enables them to get better prices for their wares!  People understand that the item is worth more, so they become more willing to pay for it.

And the buyer loves test drives and Carfax as well!  It gives us certainty and confidence, it helps us evaluate the item, and it enables us to get the most for our dollar that we can.

This isn’t just limited to cars.  The problem of asymmetric information is why we get free samples, and trial subscriptions.  Its why we can see how many stars the item got, and read the reviews. 

These things help both the buyer and the seller – they help the buyer get more value, and the seller get more money, per transaction.  That is to say, its more economically efficient then the natural, free market state.

Real world example

In one of those rare moments where something I learned in school actually presented itself in the real world, my friend Fengsheng once went through Akerlof’s posit to a T.

A few years ago, Fengsheng was poised to buy a car off of Craigslist.  He had narrowed it down to two vehicles, both about the same year, and of similar makes and models.  The asking price for both cars was the same.  On the surface, they appeared identical.

So Fengsheng contacted both sellers and asked if he could take the cars for a test drive.  Sure, the sellers said.  But, Fengsheng said, how much can you learn from just a 5 minute test drive?  That’s only enough to know the car turns over, it tells you nothing about the car’s long-term prospects.

So on a Saturday morning, Fengsheng went over to Seller A’s place, and drove the car directly to the nearest mechanic.  He paid about $30 and asked the mechanic to run a diagnostic, just to check it over.  Half and hour later, the mechanic told my friend that the car was in decent shape.  It needed a bit of maintenance, but nothing major.

Fengsheng drove it back to Seller A’s place, and told him he’d let him know if he wanted the car by the end of the day.  Then Fengsheng went to Seller B’s place and did the exact same thing with B’s car, paying another $30 of his own money to have a mechanic poke around under the hood and give his opinion.

This time, the diagnosis was not so hot.  The car’s transmission was in lousy shape.  The mechanic didn’t think it would last a year, and would cost over $1000 to repair. 

Fengsheng bought car A.  In effect, he didn’t spend $60 on mechanics diagnoses, but really he spent $60 on information.  And that information greatly affected his economic behavior.

Other examples

Once you understand the market for lemons problem, you realize its everywhere.

A film full of characters I already know, and in a style I know I enjoy?  I may be more likely go see that than to take a gamble on a new film.  This is why Hollywood produces sequels to hit films.  It's a way of communicating to the audience what the film is like before they even buy a ticket. It also shores up the information gap between an unsure audience and a studio that thinks it's producing decently entertaining flicks.

Asymmetric information causes huge problems in the health insurance industry as well.  Say I’m expecting a major medical expense this year.  Maybe I need an operation, maybe I’m chronically ill, or maybe my wife is having a baby.  As long as the price of insurance is less than the cost of the procedure I’m anticipating, I’ll buy insurance. 

On the other hand, my brother is incredibly healthy.  He expects to spend $0 on medicine in the upcoming year.  No matter how cheap the price of insurance, he’ll never buy in.

Then the health insurer is left insuring only sick people.  In order not to go broke, a health insurer needs some healthy people paying in and not making claims to balance out the ill folks who are paying less then they claim. 

When left up to the free market, health insurance becomes more and more expensive, as low-medical cost people exit the market.  The only insurers who survive in the long run are the ones that jack up the prices of premiums to compensate.

Of course, the big problem here is the insurer charging everyone one price.  That’s why it feels like a lousy deal to the healthy people, and free money to the ill.  The economically efficient outcome would be to have everyone insured, and everyone feeling like they got a “fair” price – a price the buyers feel is commensurate with the benefits they receive.

This is exactly why insurers ask questions about your age, smoking habits and medical history.  Its also why they look into your pre-existing conditions.  The information is asymmetric, the insurer knows less about your health then you do, and as a result the free market just doesn’t deliver.

The most economically efficient outcome would be for insurers to offer coverage to every customer for a price customized to that individual.  They would need to know everything about your health, and be able to project, with a high degree of accuracy, what your health care expenditure would be in the upcoming year. 

This isn’t going to happen anytime soon.  It’s also why very few countries have unregulated health insurance markets.  There are structural issues with the business model itself that just don’t function in a free market state.

Anyway, that’s asymmetric information for you.  Can you come up with any other circumstances in your own life where a lack of information about a product or service affected how much you were willing to pay for it?  Post 'em in the comments below!

5 comments:

  1. I was the seller in one such situation. I was selling my car that was probably 7/8 of the way through its life. Things were...umm... breaking down. I put it on Craigslists for hundreds of dollars, as-is. Turned out to be the perfect deal for a father and teenage son buying his first car. They took it for a test drive, they liked it, and we signed a written agreement verifying it was being sold as-is. I never heard back, so either they were happy with the purchase, or the car destroyed them utterly. (Add two to my "death toll" rating on Craigslist.)

    How do you mean Encarta is a command economy?

    "Or [a market failure] can happen when there are perverse incentives that distort the market. Think of a government subsidy on corn that encourages farmers to produce more corn then anybody wants or needs." - I think this example is impossible. The presence of a government (i.e., violence/coercion) means a.) the market is not free, and b.) not all actors are acting unconstrained.

    What I think is important to point out (I'm too good to write blogs; I'll just piggyback yours) is that information is a product like any other when it comes to the free market. Therefore, information itself can be a lemon. Sometimes we can buy it, and then say, "Ya' know, that really wasn't worth it."

    For example, Fengsheng (that's probably his Americanized name?) paid $60 upfront for the mechanic's services with no assurance that services rendered would be relevant. If the diagnoses of the two cars had been identical, then Fengshen wasted $60. In fact, to this day, we don't know if the mechanic just sold Fengsheng a story, in order to make sure Fengsheng didn't feel like he wasted $60. (I doubt this.)

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  2. Dave -

    That's a clever way to sell the car! By marking the price at only a few hundred dollars, by advertising it "as-is," and by making the buyers sign the agreement, you communicated information about the actual state of the car, and gave them better tools to judge its value. Remember, the goal of the free market (in the economist's mind at least) isn't necessarily "higher" prices, but "fair" ones - prices that both the buyer and seller feel reflect the "true" value of the item. Sounds like in your case, both parties were happy with the transaction - so your upfrontness about the car's quality helped the free market function!

    Yeah, I probably didn't make that Encarta/Wikipedia analogy clear. I mean to say Encarta was a planned, forced project. Wikipedia happened on its own. Microsoft had to make a plan about how to allocate resources to produce Encarta from the top down. Wikipedia allowed people to allocate their own resources however they saw fit (bottom up). Wkipedia is a freely developed, no centralized planning (crowd sourced) project, and it produced something better (and cheaper) then the structured, produced by command, Encarta. Its a great example (in my mind, at least) of when the free market wins.

    You're absolutely right about perverse incentives. Perverse incentives are market failures specifically caused by outside forces sticking themselves into markets for odd reasons. It can be a situation where free markets fail BECAUSE of government intervention. (For more, see: http://www.forbes.com/2009/02/19/incentives-compensation-bonuses-leadership_perverted_incentives.html)

    So maybe its technically wrong for me to say "the free market fails because of perverse incentives" since as you point out, its not a free market when there are perverse incentives.

    However, not all perverse incentives are the government's fault. Overzealous speculation in the housing market (based on bad information) led to waste of construction resources. And the main reason gas prices have jumped as of late is financial firms have got into speculating on oil futures. In this cases, the absence of regulation inflates the prices and screws with the behavior of the market.

    And yes, there is another information asymmetry within the asymmetry in Fengsheng's story! How do we know the mechanics's "product" is worth $60!? Well, we can try to shore up that one by asking around for a good mechanic, read reviews of their service - to get information on the mechanic himself.

    But pretend that instead of some strange mechanics, Fengsheng took the cars to a trusted friend, one who is a real expert on cars. In other words, image there was no doubts about the quality of the information he was receiving about the cars. You see how that info would make a big difference in Fengsheng's behavior?

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    Replies
    1. Ok, semantics (or, you could say, definition asymmetry) has obviously gotten the better of us. I think the definitions of perverse incentives and force, and how they relate to the definition of a free market, is its own topic.

      You also brought up regulation in regard to speculation. Regulation through the use violence and coercion, versus regulation through voluntary association with an inspection agency like Underwriter's Laboratory or peer-review journals, are night and day. I'm not sure which one you mean. Maybe for another topic?

      Speculation is also worthy of its own topic. I have seen arguments of how it serves the social good in a macro sense (in a non-violent, non-coercive society which respects property rights.) Applying it to micro would also be interesting.

      Finally, back to the topic at hand. Yes, I see if there are no doubts about the car expert's information, Fengshen has a much easier choice.

      Delete
  3. Free carfax are not 100% reliable even the paid ones. $40 is just too much so I switched to some bargains and I got a $4.99 complete vehicle history report from NMVTIS and it's been good so far.

    ReplyDelete
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