Economía

Asymmetric information and the response of markets

In 1970, George Akerlof wrote a paper exposing the different outcomes resulting from distinct qualities in products. He emphasized the role of information asymmetry, which occurs mainly when one party of a transaction knows a material fact that the other party doesn’t (Perloff, 638). As a result of multiple researches in this topic, in 2001 Akerlof, Michael Spence and Joseph Stiglitz jointly received the Nobel Memorial Price in Economic Sciences for their “advances in analyzing markets and the control of information.” The context of these economists’ thesis on asymmetric information took place in the midst of important theorists debating the intricacies of general equilibrium. Akerlof noted that hidden information “was potentially an issue in any market where the quality of goods would be difficult to see by anything other than casual inspection”. (Cassidy, 154) And so, he used the automobile market example to capture the essence of the problem, being that when buyers are not able to judge a product’s quality before buying it, low quality products –lemons- may drive high quality products out of the market. His paper highlights that the seller has a more accurate estimate of the automobile’s conditions, which certainly imposes an advantage over the buyers. Because of this disparity of information, buyers will be reluctant to pay as much money for any particular car when compared to a situation in which they know for certain that the car they are buying is not a lemon. The main problem is that since it is impossible for a buyer to tell the difference between qualities, good cars and bad cars are sold at the same price and the market might become inefficient. According to Jeffrey M. Perloff: “The better quality cars may not be sold even though buyers value good cars more than sellers do” (644). In other words, the “bad” cars tend to drive out the good (in the same way that happens with money, according to Gresham’s law). Sellers are aware of the lack of information from the buyers and therefore, of the fact that they wont be willing to pay as much for used cars because of the risk of getting a lemon. According to Brian P. Simpson, author of the book “Markets Don’t Fail!”: “[…] this is said to provide an incentive for those sellers with the highest quality used cars to withdraw their cars from the market. They do so because the prices they can get for their cars, presumably, are below what they consider to be acceptable due to the existence of asymmetric information” (190). As a result, this leaves a greater quantity of lower quality cars on the market.

Problems due to asymmetric information: Applications

According to Perloff asymmetric information leads to problems of opportunism (639). Two of the most relevant are adverse selection and moral hazard. The first is characterized by an informed person benefiting from trading with a less informed person. Consequently, some authors argue, this reduces the size of a market or completely eliminates it. Moral hazard, on the other side, is characterized by an informed person’s taking advantage of a less informed person through an unobserved action. It is also defined as the hazard occurring after a trade has already taken place. Usually, one party to a transaction changes his behavior in a way tat is hidden from and costly to the other party. Examples of this type of problem include shirking, failure to take care, and reckless behavior. In his original paper: Market for Lemons: Quality Uncertainty and the Market Mechanism, Akerlof  (1970) presents some other examples to illustrate his point. Under the case of adverse selection, he points the case of insurances. Under this situation, instead of the sellers “self-selecting” in a way that affects the buyers, the buyers of insurance are supposed to make choices that adversely affect the sellers. According to the author, as the price level rises, the people who insured themselves will be those who are increasingly certain that they will need the insurance. The result is that the average medical condition of insurance applicants deteriorates as the price level rises. The asymmetric information under this example is pretty obvious: insurers don’t have perfect information about people’s health. According to Brian P. Simpson (191) this in turn, allegedly drives the healthiest people out of the market because they are the ones least likely to need the insurance and therefore are less likely to be willing to pay a higher price for it. An insurance textbook written at the Wharton School (Denenberg, Eilers, Hoffman, and Snider; 446) has the following statement:

“There is potential adverse selection in the fact that healthy term insurance policy holders may decide to terminate their coverage when they come beholder and premiums mount. This action could leave an insurer with an undue proportion of below average risks and claims might be higher than anticipated. Adverse selection “appears (or at least is possible) whenever the individual or group insured has freedom to buy or not to buy, to chose the amount of plan of insurance, and to persist or to discontinue as a policy holder”

Another common example is the loan markets. In this case, due to the risk of borrowers defaulting on loans, “creditors are supposed to charge higher interest rates relative to what they would charge if they possessed perfect information about the credit worthiness of borrowers” (Simpson, 191). Following Akerlof’s train of thought, this will increase the proportion of borrowers in the market who are not credit worthy, and will increase the interest rate that the creditors must charge to compensate for the greater risk of making bad loans. The extreme case will be that creditors will not give more loans and that the market will eventually break down.

Akerlof also presents the employment of minorities example. In this case, it is strenuous for an employer to hire a new employee because of the difficulty to distinguish good job qualifications and preparation. In the labor market, employers know less about the skills of job applicants. The economist went a step further by arguing that dishonest dealings tend to drive honest dealings out of the market. He points that this is mainly a relevant problem in underdeveloped countries, where a misrepresentation of the quality of a car costs ½ unit of utility per automobile. He later accentuates the role of merchants, -the “first entrepreneurs”- at identifying the quality of goods; nevertheless, he argues that entrepreneurship is a scarce resource. John Cassidy presents an interesting example in a different context. Under baseball’s laws, any player who has served six years on a major-league team has the right to demand another contract or become a free agent and sign with another club. The hidden information is the player’s true state of fitness: many baseball players develop injuries that latter affect the athlete’s performance. A potential acquirer, of course, does not know this information. According to the author, they address it by examining a free agent’s medical records and subjecting him to rigorous fitness tests. A financial economist named Kenneth Lehn examined a large sample of players who had singed multiyear deals, dividing them into those who re-signed with their original teams and those who became free agents. He discovered that the first group averaged fewer than ten days a season on the disabled list, whereas the free agent averaged more than seventeen days on the list. These findings strongly suggest that many free agents are lemons (154).

Brian Simpson stated that advocates of the “adverse selection” argument do not necessarily claim that a market will completely break down. They may claim that a market will only partially break down because far fewer trades will take place due to the existence of asymmetric information (192). Nevertheless, if this were the case, then most markets should have a tendency to breakdown because information is disperse, and not all buyers and sellers will always possess the same amount of information regarding a good or a service. This leads us to the explanation of responses to adverse selection and alternatives to the so-called ‘problem’ of asymmetric information.

Responses to adverse selection:

 According to Perloff (640), the two main methods for solving adverse selection problems are:

  • Restricting opportunistic behavior, and
  • Equalizing information

Concerning the first point, the author claims that adverse selection can be prevented if informed people have no choice. This example is applied when firms or government provide insurance to everyone by mandating that every single person buys it. A usual circumstance is that many states in the United States require that every driver carry auto insurance; this therefore reduces the number of a significant number of bad drivers buying this service. Parallel to this, some firms provide mandatory health insurance to all employees. In this case, both healthy and unhealthy people are covered, and the firm does not incur in the costs of paying a higher wage and letting employees decide whether to buy insurance of their own.

In terms of equalizing information, many authors explain different possible alternatives:

  • Screening: This concept was first developed by Michael Spence and takes place when an uninformed person takes action to determine the information that informed people have. Examples of screening include test-driving, the dating process between future couples, a firm’s interview process and a bank’s screening process of knowing their potential borrower’s financial history. Another common example is what insurance companies do to try to reduce adverse selection: learning the health history of their potential customers. Nowadays though, this information may not be enough. Insurance companies now also look into individuals’ habits (smoking, drinking, hobbies…). The process of collecting information, nevertheless, might be expensive. As a result, “insurance companies collect information only up to the point at which the marginal benefit from extra information equals the marginal cost of obtaining it”. (Perloff, 640).
  • Signaling: This is an action taken by an informed person to convey information about itself to another party. Informed sellers would signal potential buyers about the quality of their services or products. This is especially the case if businesses have a profit motive; they’ll have a strong incentive to provide adequate information about their products or services to consumers in order to have a competitive advantage. The firms that do not provide authentic information about what they sell will become less profitable in contrast with the firms that provide better information.
  • Standards and certifications: Certifications report that a particular product or service meets a given standard level. Guarantees, for example, are used to ensure the buyer of certain expected quality. A clear example is the one of e-Bay and other retail websites that implement money-back guarantees. This is especially the case in these types of businesses because buyers can’t physically inspect the good they are planning to buy. In the case of warranties, this can also mitigate the asymmetric information problem because the customer can be certain about the quality of the good he’s buying. It is important to mention that although standards and certification programs restrict goods and services to those that are certified, such programs may also have anticompetitive effects. Sometimes the main purpose of theses practices is to erect entry barriers to new competitors, as in the case of licenses.
  • Brand names: According to Akerlof, “brand names not only indicate quality, but also give the consumer a means of retaliation if the quality does not meet the expectations” (500). Companies gain a reputation with respect to the quality of the goods they sell. It is important to highlight that firms have an incentive to promote the good quality of their products if they work in a market in which the same consumers buy regularly; if this is not the case, they might have an incentive to pass off a low quality product as a higher quality one.
  • Advertising: Similar to brand names, advertising provides relevant information to consumers. Simpson gives the examples of independent assessors such as Consumers Union and Underwriters Laboratories Inc. (193) to help provide information.
  • Laws to prevent opportunism: Any seller who knowingly gives false information or sells a certain product that does not perform the original intended function is committing fraud. Consumers can sue the seller; however, the transaction costs of starting a legal process are very high.

If markets break down… who will solve the problem?: Government intervention

John Cassidy argues that: “[…] hidden information creates a market failure that only government intervention can correct” (156). He supports this claim by saying that, following the argument that justifies the existence of Medicare, by introducing universal health coverage, the federal government could effectively eliminate the lemons problem. He doesn’t explain though how would this transition happen and where will that money come from. (The answer is obvious: from all the taxpayers. There’s no such thing as free lunch.) Cassidy continues by saying that “leaving things to the ‘market’ is not realistic”. He supports the work from economists like Kenneth Arrow, who believe that “the only effective way to control escalating medical costs is to move to a single-payer system where the government could address the problem of moral hazard by imposing some limits on the consumption of medical services”. (159). This is said in the context of healthcare, where “government is better than the private sector at keepings costs down for insurance purposes”. The author claims that this is not the case in other industries, but he later reassures that “there is always a potential policy intervention that could improve the welfare of at least one person while leaving nobody worse off”. Following the work of Akerlof, Joseph Stiglitz showed that information issues are key to many different types of market failure such as unemployment. This is opposed to Friederich Hayek’s argument that suggests that information is revealed by market prices. Economists like Akerlof and Stiglitz don’t believe that markets are the most efficient way of allocating scarce resources, and so they attribute this role to the state. They both argue that through regulation, all parties will be forced to give up information, which will markets more efficient.

What if markets don’t break down in the first place?

The usual argument against the market is that government should forcibly require companies to provide information to consumers. This information is traduced into regulations that allegedly “correct the market deficiencies” and prevent people from being harmed by low quality and unsafe products, as well as poor working conditions. Some governments explicitly take a step forward by claiming that consumers who are well-informed are more confident about what they’re buying and therefore are more likely to spend more money, which “helps the economy grow” (Cable, 2012). Some examples of agencies that execute this type of regulations are the Food and Drug Administration, the Environmental Protection Agency, the Consumer Product Safety Commission, the Securities & Exchange Commission, the Occupational Safety and Health Administration, etc… The government of Alberta in Canada, has a website with special “warnings issued to consumers about potentially fraudulent, misleading, unfair or otherwise harmful activities occurring in the Alberta marketplace” (Alberta, 2013). The UK government announced that trough the “Empowerment and protecting customers” institution, they will have legal authority to make businesses release personal data to their customers. Following the consultation, the government announced that they would legislate if companies didn’t release data voluntarily. The main problem concerning government intervention is that they have less ability to know what information consumers care about getting (some examples can be regarding food ingredients or nutritional information). Why would government posses all the important information required for an appropriate functioning of the market conditions? It is important to highlight that knowledge of the circumstances is never found completely integrated or concentrated, bur rather as unique disperse elements. In Friedrich Hayek’s The Use of Knowledge in Society, there’s a very complete explanation of this problem:

If we can agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them. We cannot expect that this problem will be solved by first communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders. We must solve it by some form of decentralization

Israel Kirzner and the other Austrian economists realize that imperfect information is part of the market process, not a stumbling block to market behavior. According to an article by William L. Anderson (2001), instead of government solving the information problems, it actually creates them because “many regulations forbid parties in exchanges from finding out or acting upon relevant facts”. Considering that a central government or agent can never have all the relevant information for different people, they might send the wrong signals to the spontaneous market process. A free market achieves a high level of safety and quality by virtue of the greater productive capability it achieves, and because businesses want to maximize profits, and they can do so if they offer good services and products. Anderson closes his article, published in the Ludwig von Mises article with a line that makes this concept very clear: “Life is uncertain, no matter how it is lived. The idea that the political process, which is one of the most volatile things on the face of the earth, is the basis for certainty and stability simply ignores reality”. Brian Simpson, in contrast with the opinions by the authors mentioned in this paper (Akerlof, Stiglitz and John Cassidy), simply believes that markets don’t fail. He supports his thesis by saying that the most obvious piece of evidence is the fact that the used car market, for example, hasn’t broke down. He claims that this doesn’t happen because of the profit motive that gives sellers an incentive to provide adequate information. If anyone has any incentive to give false information, he’ll be committing fraud and is violating the principles on which a free market operates. This is why the role of institutions is so important in any society to reinforce the adherence to law. In his paper Information and the market for lemons, Jonathan Levin observes that as the quality of seller information increases, trade may decrease or increase –the relationship between information asymmetries and trade is not monotonic. It is important to mention that people have devised ways to deal with imperfect information. The role of the entrepreneur is of huge importance under these situations. According to Rita Yi Man in her paper Imperfect Information and Entrepreneurs’ Choice:  “An entrepreneur combines the resources of land, capital and labor to produce a good. He is the major driving force behind production of goods. As there is no guarantee of making a profit and imperfect information exists in our business world, the entrepreneur assumes the role of risk bearer”. Brian Simpson proposes that believing that asymmetric information is harmful is to relieve that the division of labor should be eliminated because it is an inherent feature of such a society (196). In the same line, Hayek concurrently discussed in his book The Constitution of Liberty (1969) that the infinite number of humble dispositions taken from many different persons for the realization of familiar things is as important as the principal intellectual innovations that are explicitly communicated as such. In this way, he also stated that the combination of knowledge and aptitude is not the result of a common deliberation of people that pursue the solution of a problem, but rather the product of individualities that result from the experience of others. Knowledge is inherently dispersed and the benefit of the division of labor is precisely to increase it in direct proportion to the number of specializations. There’s no doubt that Simpson read Hayek when he presented that: “The division of labor not only increases the amount of knowledge that a given number of people can possess, it bring that knowledge and the methods of production that everyone uses to the standard of the most intelligent members of the society” (197). Through the unification of dispersed knowledge, one can obtain better achievements than those that any unique intelligence could obtain or foresee, and this is one of the most important motifs why asymmetric information should not be a problem, especially under a free market economy. In the entrepreneurial context, Simpson noted that: “the incentive for businesses to acquire information about customers and suppliers (including employees) is just as strong as it is to provide it”.

Remarks

It is imperative to be aware of the inevitable imperfection of human knowledge. Nevertheless, when sellers want to make a transaction, they have incentives to sell a good product and provide adequate information. If the buyer has the intention to make an exchange, he can search for alternatives to make sure that he’s getting a good product; after all, is in his self-interest to do so. In the end, both participants in the transaction have the incentive to create institutional mechanisms to facilitate the exchange (Hall, 2007), and this proves why markets don’t actually break down.

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2 thoughts on “Asymmetric information and the response of markets

  1. The free market has already solved the lemon car problem in my country.

    “It is an example of the party with the advantage ensuring that the disadvantaged party is on level ground in terms of information. This solution came from a couple of guys in Missouri. No lobbyists were paid, no bureaucrats were hired, no micromanaging laws were passed. All it takes is a desire to help people, some entrepreneurial effort, and a desire to make a buck.” — from here http://meatheadeconomist.blogspot.com/2012/04/market-solution-to-problem-of.html

    • Thank you for sharing Ian! I’ve heard of Carfax before, as well of other companies -in many other countries- that are making an effort at communicating information to their customers (in different industries, not only with automobiles). As I wrote on the paper… I don’t even think this is a problem in the first place, and a Nobel Prize can’t change that fact…

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