Fear No More The Market For Lemons

old-yellow-car-ads-2560x1600_42430965At Cato Unbound, Alex Tabarrok and Tyler Cowen ask whether the age of asymmetric information is ending and what implications this have for markets and regulation.

They acknowledge that the passing of most information asymmetries should be good in principle. They will lead to easier trade, higher productivity, and better matches of people to jobs and to each other. However, there are also some problematic implications, specifically when it comes to privacy. In fact, there are services whose existence depends on asymmetric information. Case in point: insurance.

Insurance involves pooling funds from many insured entities (exposures) to pay for the losses that some may incur. Insurance companies have strong incentives to gather ever more accurate information about their exposures. However, in a market with completely symmetric information, there won’t be any possibility to trade risks:

For instance if you have a cancer of a given kind, this is verifiable to the outside world, and if the treatment costs are $200,000, the cost of an insurance policy will in turn be about $200,000. Buying the policy won’t be cheaper than buying the treatments, and in that sense the market for insurance is not always present. That is a very real public policy problem,

A similar situation could also be found in the labour market:

Each employer may find it cheap to discriminate against potential employees with an arrest record, for example, but when all employers discriminate in this way, a large class of people may find it difficult to find employment, and that in turn may increase recidivism.

For more than three decades, research on incentives and market equilibrium in situations with asymmetric information has been a prolific part of economic theory, and has given us some remarkable Nobel Laureates. Information asymmetry creates an imbalance of power in transactions, which can cause transactions to go awry, and therefore to market failure.

Examples of this problem go by exotic names such as moral hazard, or the adverse selection studied by Akerlof in The Market for Lemons(1) (a.k.a. used cars.) What do those names suggest? Let me paraphrase the Anna Karenina Principle for a clue: Perfect (information) markets are all alike, every imperfect market is imperfect in its own way.

Perfection has no texture, and in an absolutely transparent market, we will miss those bitter lemons.

____________________

Akerlof, George A. 1970. “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” The Quarterly Journal of Economics 84 (3): 488–500. doi:10.2307/1879431.

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