Latticework of Mental Models: Asymmetric Information

Exactly eleven days after buying my windows smartphone, I realized my mistake. Unfortunately, the ten day return window (no pun intended) had already closed.

So I listed it for sale on couple of online used item marketplaces (OLX, Quikr etc.). To my utter surprise no one was willing to pay more than 70 percent of the original cost for my brand new phone. Was my phone model so bad?

But I found that almost all the other similar deals for used electronic gadgets (which were only few days old) were being sold at significant discount to MRP. I was quite sure that many of those sellers, like me, were selling because they didn’t like the product, and not because there was some defect in it.

Then why was the used-item-market heavily discounting the price for an item which was almost brand new? I also noticed that there wasn’t much difference between the price of a 1 year old phone a 1 month old phone of the exactly same brand and model.

Another observation – the number of listings for relatively newer items were very few as compared to the ones for 1-2 years old items. Why so?

Well that was the topic of George Akerlof’s research which won him a Nobel Prize in Economics in 2001. Akerlof wrote a paper titled ‘Market For Lemons’ which used the example of used-car market to explain the idea of Asymmetric Information and how it can create pockets of inefficiency in an otherwise efficient market.

Akerlof’s Lemons

Markets usually work on the principles of supply and demand. Which means in a used-car market also, the prices should be determined by supply and demand i.e. the more cars on offer the lower the price, right?

But Akerlof observed that it wasn’t true for used-cars. He found that all used-cars are cheap regardless of the availability. Akerlof argued that the culprit was asymmetric information.

Asymmetric Information, as the name suggests, is the phenomenon when one party to a transaction has more relevant information than the other. Now supply-demand pricing works in situations where clear and transparent information is accessible to both the parties involved in the transaction. When you have asymmetry in information, supply-demand pricing breaks down and markets favour the party that knows more.

So what transpires in used-car market?

Any individual selling a used car knows more about its quality than someone looking to buy it. So as an owner of a car, I have very specific information about the car’s repair history and operational condition. I can choose to hide the major problems from a prospective buyer and end up selling my car at a price much higher than what the car deserves.

With more such unfair transactions, where sellers exploit buyer’s ignorance, buyers start losing trust. This loss of trust reverses the effect of asymmetric information. Thus, used-car buyers anticipate hidden problems and start demanding a discount. And even people who are offering their relatively better cars at a genuinely fair price, become victim of this trend.

Put simply, once there is a discount built into the market, owners of good cars become even less likely to sell them because they can’t get a fair price. The overall effect on the used-car market is that it will be full of lemons.

Just in case you don’t know, the word “lemon” is informally used for anything which has defects and of poor quality.

This explained the conundrum I faced while trying to sell my phone in the used smartphone market. Call it Akerlof’s Smartphones!

So as I see it, the first problem that any marketplace has to deal with is – how to remove information asymmetry. Typically for new items, the issue of trust and transparency is taken care by the brand, warranty and promise of after-sales service. In almost all the second-hand marketplaces, there is no such established ecosystem for building trust. No wonder, used-item marketplaces (including many of the online e-commerce platforms) are hotbeds of asymmetric information.

If an English professor were asked to explain the idea of Akerlof’s lemon, he or she would probably say, “It’s just an Economist’s way of saying that you’re throwing the baby with the bathwater. ”

Lemons Aren’t Insured

Akerlof’s lemons aren’t just restricted to used-cars and second hand mobile phones. For an instance, let’s talk about the insurance business.

When I quit my job last year, one of the first thing I did was buying a medical insurance for my family and myself. Till that time I never had to worry about medical insurance because it was usually covered by my employer’s group medical insurance benefit. The corporate insurance policy covered my wife, kids and parents.

But I was surprised to know that if one buys a medical insurance policy as an individual, the family medical insurance policy doesn’t cover your parents. Even if your older folks are very healthy, the insurance premium is too high for them.

Tim Richards, in his book Investing Psychology, explains –

Only older people who want health insurance tend to be the ones who know they have something wrong with them, because the price of health insurance increases rapidly with age. Of course, one of the reasons it increases rapidly with age is because only sick people want the insurance, while all the healthy people decide it’s too expensive…This particular issue is known as adverse selection, and means that those elderly people who aren’t ill and simply want to protect themselves are unfairly penalized.

Explaining the effects of information asymmetry in health care sector, Charles Wheelan, in his book Naked Economics, writes –

Health care, for example, is plagued with information problems. Consumers of health care—the patients—almost always have less information about their care than their doctors do. Indeed, even after we see a doctor, we may not know whether we were treated properly. This asymmetry of information is at the heart of our healthcare woes.

Under any “fee for service” system, doctors charge a fee for each procedure they perform. Patients do not pay for these extra tests and procedures; their insurance companies (or the federal government, in the case of older Americans who are eligible for Medicare) do. At the same time, medical technology continues to present all kinds of new medical options, many of which are fabulously expensive. This combination is at the heart of rapidly rising medical costs: Doctors have an incentive to perform expensive medical procedures and patients have no reason to disagree.

In Business

Information asymmetry is actually a problem in all sorts of situations, writes Richards, “many corporations find themselves with a similar problem of how to distinguish themselves from inferior competitors and their solution is one based in the psychology of humans.”

We spend our lives shopping for products and services whose quality we cannot easily determine. So how do we solve the problem of information asymmetry in a crowded marketplace? The answer is Branding.

Wheelan explains –

In competitive markets, prices are driven relentlessly toward the cost of production. If it costs 10 cents to make a can of soda and I sell it for $1, someone is going to come along and sell it for 50 cents. Soon enough, someone else will be peddling it for a quarter, then 15 cents. Eventually, some ruthlessly efficient corporation will be peddling soda for 11 cents a can. From the consumer’s standpoint, this is the beauty of capitalism. From the producer’s standpoint, it is commodity hell…How does a firm save its profits from the death spiral of competition? By convincing the world (rightfully or not) that its mixture of corn syrup and water is different from everyone else’s mixture of corn syrup and water. Coca-Cola is not soda; it’s Coke.

Branding helps to provide an element of trust that is necessary for a complex economy to function. Modern business requires that we conduct major transactions with people whom we’ve never met before.

Branding, thus, is a way to come out of vicious circle created by information asymmetry. It’s a strategy to increase profitability by persuading customers about the uniqueness of a product in an otherwise commodity industry. And it solves an important problem for consumers too i.e. how do you select products whose quality you can’t test beforehand?

In Investing

For a small investor, information asymmetry is big challenge when it comes to making a decision about where to invest his or her money.

All financial advisors look and speak the same language, all mutual funds advertisements sound similar. You can never trust a financial expert’s intents when he comes on TV and recommends a particular stock or investment product.

A mutual fund manager has more specialized knowledge about industries and financial domain than a small investor. The company management knows more than a common investor. Although trading on inside information is illegal there’s no doubt that it does happen, and it disadvantages the private investor.

On one hand, the awareness is increasing among retail investors, but on the other hand these financial institutions are one step ahead by creating more complicated financial products. Institutions exploit issues of choice overload and deliberately make it difficult for an average investor to keep up. They know the mantra – “If you can’t convince them, confuse them.”

The only solution that seems viable is to educate yourself. Basic financial education is a must for everyone. Kids should be taught about money right from elementary school so when they are ready to earn their first paycheque, they don’t get fooled by financial lemons. It’s your responsibility to learn the basics of investing your money.

For a value investor, information asymmetry is an advantage. When you know that a market is prone to asymmetric information, you can rest assured that there will many babies in the bathwater. So if you’re smart just focus on learning how to differentiate the lemons (value traps) from peaches (the hidden gem or the quintessential mispriced bet).

As an aside, do read Prof. Bakshi’s wonderful short post on the role of information asymmetry in stock market crashes.

Conclusion

When Charlie Munger said, “Without worldly wisdom you’re like a single legged man in an ass-kicking contest.”, using the metaphor of missing leg, he was probably hinting at the huge chasm of information asymmetry between worldly wise people and the ignorant ones.

If you stop learning in this world, says Charlie Munger, “the world rushes right by you.”

So when life gives you a lemon, you now know what to do. Don’t you?

Take care and don’t stop learning.