Overview

In a perfect market, everyone knows everything. In the real world, the seller knows more than the buyer. The used car dealer knows the engine is broken; you don’t. This “Asymmetry” breaks the market. It explains why insurance is expensive and why you need a college degree.

Core Idea

The core idea is The Market for Lemons. (George Akerlof).

  1. There are Good Cars (Peaches) and Bad Cars (Lemons).
  2. Buyers can’t tell the difference, so they offer an average price.
  3. Sellers of Good Cars refuse to sell at the average price (it’s too low).
  4. Only sellers of Lemons stay in the market.
  5. Buyers realize this and stop buying. The market collapses.

Formal Definition

A situation where one party in a transaction has more or better information than the other. Types: Adverse Selection (Hidden Information before the deal) and Moral Hazard (Hidden Action after the deal).

Intuition

  • Job Interview: You know if you are lazy. The boss doesn’t. That is Information Asymmetry.
  • Signaling: How do you prove you aren’t lazy? You get a College Degree. The degree doesn’t make you smarter; it just signals to the boss that you can work hard for 4 years. (Spence Signaling Model).

Examples

  • Health Insurance: Sick people want insurance more than healthy people (Adverse Selection). If the insurance company charges an average price, healthy people leave, and only sick people stay. The price goes up, more healthy people leave. (Death Spiral).
  • Mechanics: You don’t know if you need a new transmission. The mechanic does. He has an incentive to lie.

Common Misconceptions

  • More information is always better: Sometimes, less information is better. If insurance companies knew exactly when you would die (Genetic Testing), they would never insure you. Ignorance allows risk pooling.
  • Principal-Agent Problem: The owner (Principal) hires a manager (Agent). The manager knows more about the business. He might steal money or play golf instead of working.
  • Screening: The buyer trying to find the truth. (e.g., A deductible in insurance screens out people who just want free money).

Applications

  • Carfax: A company that exists solely to solve information asymmetry in the used car market.

Criticism / Limitations

  • Trust: The internet (Yelp, Uber Ratings) has solved a lot of this. We trust strangers because we can see their 5-star rating.

Further Reading

  • Akerlof, George. The Market for “Lemons”.
  • Levitt, Steven. Freakonomics.