Many of the models that we’ve covered in economics are based on all-things-equal, perfect world scenarios. This causes a host of difficulties when it comes to applying models to the real world, and one concept, in particular, has changed the approach to economic policy relatively recently. That concept? Information asymmetry. Information asymmetry is the difference in information between the buyers and sellers of a product. That difference in information can influence the decisions of both parties when it comes to purchases, which in turn can lead to irrational decisions and glaring inefficiencies.
To explain it better, I’ll use an example. Information asymmetry was first and most famously described through the “Market for Lemons” thought experiment. George Akerlof, a Nobel-prize winning economist, first wrote about this idea in 1970. He described a market for used cars. There are two types of used cars, a “peach”, or a higher quality vehicle that is worth $10,000, or a “lemon”, or a lower quality vehicle only worth $5,000. Theoretically, the market should flourish, seeing as how buyers will be able to purchase based on their income and preferences, and sellers will accept those purchases because the car is less valuable to them than it is to the buyers. However, what if peaches and lemons were not easily distinguishable? If knowledge is skewed so that only the sellers know the differences between the peaches and lemons, then the buyers are at a disadvantage. And so, they might pay $7,500 for a car that has an equal chance of being a peach or a lemon. This equal risk investment is acceptable for the buyer, but if the seller knows for sure that they have a peach, they wouldn’t sell at that price. What ends up happening is what’s called adverse selection, or where sellers will only sell lemons to buyers paying the price of $7,500. This, in turn, causes smart buyers to shift their purchases, perhaps to the point where they are only willing to pay $5,000, or the original price of lemons, for the cars. So lemons are now being sold at market price, but no peaches are sold at all. This is because no consumer is willing to take the risk because they don’t have information, while the sellers do. This inefficiency factors into perfect economic models, as they are often predicated on the fact that all parties have an equal understanding of the market and the market price. So if consumers and producers are operating under different information, the models change and inefficiencies will arise.
There are solutions to information asymmetry. Two solutions, screening, and signaling are ways that information asymmetry can be eliminated. Screening is when sellers produce specific goods that cater to certain groups more than others, leading to gravitation to their products. Signaling is when one party signals their credibility with some sort of badge or trusted marker. College degrees, standardized tests, and criminal records are all ways that parties can signal their credibility, therefore filling in the hole of asymmetric information. This economic concept is why transparency is so important in society today because without buyers and sellers can’t trust the decisions of the other and change their behavior as a result, leading to an inefficient and unproductive society.
https://www.economist.com/the-economist-explains/2016/09/04/what-is-information-asymmetry
I think it's interesting how in your example the market could change not based the quality of the product that is sold, but the lack of knowledge that a consumer might have about that product. The idea of information asymmetry helps to show how the real world applications of economics can be much more complex than the theories that we have learned about in class. This is because in the real world, people aren't perfect and may not be experts about the product they are buying leading to information asymmetry. One thing I'm interested in is if there is a certain kind of product that is more likely to have information asymmetry than another.
ReplyDeleteGreat post Henry! I had never realized that information asymmetry was something that was studied before and had always interpreted it as a tactic used by sneaky salespeople. After reading your post I noticed how at the end you mentioned a series of credibility markers that help prevent this information asymmetry and realized that the real estate market has quite a few of these. If an agent is with an agency then that house is protected by the reputation of that agency like how the credibility of one's degree can make their decisions more trustworthy. Additionally, the series of inspections and closing periods that a house sale undergoes further protects the buyer, helping to prevent them from paying "peach" house prices for a "lemon" house. Thanks for such an interesting post!
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