Asymmetric Information: I Can’t Afford Such Low Prices
Some time ago, my wife and I took a vacation to Greece. We spent a few days in Athens, took a bus tour of the Peloponnese, and visited the amazing monasteries suspended high on rock columns at Meteora. One experience that sticks out in my mind, however, was finding a hotel room on the island of Santorini. We took the
high-speed ferry from Athens to Santorini, and upon exiting the ferry, tourists are accosted by hotel proprietors trying to attract guests to their hotels. We got in a conversation with one such man and asked if the room was nice. ?Of course, it?s a very nice place,? he replied. Upon asking how much, he said $100 per night. We balked at the price, and so the man went to $50 per night. Eventually he offered $25 per night plus an ocean view. At this point, we replied, no thank you, because at that price it could not possibly be a nice place to stay.
This story does not serve to show that it?s hard to find a hotel room in Santorini (we actually drove to the man?s hotel, and, after checking it out, did stay there for $25 per night but with no ocean view). Instead it serves to introduce an important economic and policy concept called asymmetric information. In 1970, an economist named George Akerlof published an article entitled ?The Market for ?Lemons?? which later won him the 2001 Nobel Prize in Economics. It described a situation in which markets would fail so badly that they would cease to exist. Let?s walk through his example.
Suppose our consumer, Shana, is selling her used 1997 Toyota Corolla. She has driven it for several years and knows exactly what works well in the car and what is broken. She totals up all the good parts and bad parts of the car and decided that she probably would like to sell the car for about $5000. It?s a good, honest assessment of what the car is worth, and most people, if they knew the car well enough, would agree that this is a fair selling price. Here?s the problem. Nobody knows the car as well as Shana?as the previous owner, she more information than anyone else she will enter into a market transaction with. This is called a problem of information asymmetry.
Let?s say a buyer, Sam, comes along, and he only knows one thing: there are honest people in this world (like Shana), and there are people who would like to cheat and sell a car for more than it?s worth. Let us assume, for simplicity, that half the people are honest and half the people are not, and that the dishonest people are trying to sell a $1000 car for $5000. Sam does a quick expected value calculation, 1/2*($5000)+1/2*($1000)=$3000. He decides that given the probability that half the people selling cars are dishonest, that he would be willing to buy Shana?s car for only $3000. Here?s the rub: Shana is honest, but Sam does not know that. He knows, however, that if she were actually willing to sell the car at that price, it must be a lemon and only worth $1000. In fact, in this market, anyone willing to sell their car at the price of $3000 must have a car worth only $1000, because if they had a $5000 car, they would not sell for $3000.
In the end, both Shana and Sam figure this out. She sees she can only get $3000 for her $5000 car, and so she doesn?t even bother selling her car. Sam realized that the only people, therefore, who are actually willing to sell are people who are willing to take $3000, which means they must have a car worth only $1000. The market falls apart and disappears: it is a missing market.
Obviously this does not happen; people sell used cars all the time. In order to sell her car for the price that it is worth, Shana must signal that she is an honest seller. In the case of a used car market, this signaling is usually done in several ways. First, sellers often offer warranties on the merchandise they sell. The warranty shows a buyer that the car is probably not a lemon because if it were, they seller would lose money on the warranty. Second, sellers work very hard to establish a reputation. Car Max has a reputation of being an honest seller of used cars. On eBay, sellers have reputation scores, which help to signal they are honest sellers. In addition, public policy can also help markets exist: often states have passed ?lemon laws? that force sellers to refund money on cars that are not up to specific requirements. The point is, in the end, because people are made better off by transactions, markets have found a way get bring many missing markets back from the dead.
Asymmetric information has enormous policy implications in many different areas besides buying and selling products. Insurance market prices, airline ticket prices, AIDS policies, and why women earn less than men for the same job can all be, at least partially, explained by asymmetric information. We will discuss these policy implications in a future post.
April 10, 2004 |
Posted in: Economics |
Author: Charles | 
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2 Responses
How to Solve the Health Care Crisis - UtilityMinimization - PubPolicy.com: Thoughts on Policy and Economics - June 7, 2008
[...] we talked about adverse selection and asymmetric information in terms of insurance markets. The main concept is that nobody knows better about what is best for [...]
UtilityMinimization » Fine Print is Too Overwhelming - June 29, 2009
[...] the victim and being harassed). Despicable ethics aside, this story underscores the problem with asymmetric information. Markets do not work when one side has more information about the transaction than the other. [...]
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