The Economist is running a series on classic articles that have transformed economics, starting with George Akerlof’s 1970 “Market for Lemons” paper. Akerlof catalyzed the field of information economics by pointing out possible consequences of asymmetric information in the case where one party to a transaction has more complete information about product quality than the other before the transaction takes place. In this case, symbolized by the market for used cars, buyers will be skeptical about seller assertions of product quality, fewer used cars will be sold, the cars sold will be of lower quality than in the absence of the information asymmetry, and there will be less welfare created than otherwise.
This adverse selection problem can be costly, and it’s a pervasive epistemic characteristic of life. Akerlof’s model and analysis brought those costs into brilliant focus. They also planted seeds of new ideas and new research: Michael Spence on signalling, Joseph Stiglitz and Michael Rothschild on mechanisms for screening that induces people with different traits to make different choices (and thus achieves what’s called a separating equilibrium instead of a pooling equilibrium):
Suppose a car insurer faces two different types of customer, high-risk and low-risk. They cannot tell these groups apart; only the customer knows whether he is a safe driver. Messrs Rothschild and Stiglitz showed that, in a competitive market, insurers cannot profitably offer the same deal to both groups. If they did, the premiums of safe drivers would subsidise payouts to reckless ones. A rival could offer a deal with slightly lower premiums, and slightly less coverage, which would peel away only safe drivers because risky ones prefer to stay fully insured. The firm, left only with bad risks, would make a loss. …
The car insurer must offer two deals, making sure that each attracts only the customers it is designed for. The trick is to offer one pricey full-insurance deal, and an alternative cheap option with a sizeable deductible. Risky drivers will balk at the deductible, knowing that there is a good chance they will end up paying it when they claim. They will fork out for expensive coverage instead. Safe drivers will tolerate the high deductible and pay a lower price for what coverage they do get.
Notice the intersection of this idea with price discrimination; the information economics angle on it highlights the extent to which one party knows something germane to the transaction that the other party does not.
A logical next step in the analysis, then, is the mechanism design question, which I think of as an institutional question (although most mechanism design theorists probably don’t): what rules should structure the transaction to minimize the negative impacts of the information asymmetry? This is where those differences in insurance deductibles come in (and this is similar to the reason why a price discriminating monopolist creates more consumer surplus and producer surplus than a single-price monopolist).
This line of research also led to the development and formal analysis of the idea that there are two broad categories of different types of asymmetric information: adverse selection, which is asymmetric information that affects decisions before the transaction, and moral hazard, which is asymmetric information that affects decisions after the transaction (ex post). Again insurance provides a good example, but for a different reason. Knowing you have car insurance may induce you, at the margin, to drive more quickly, increasing your fun but also increasing the risk of a crash. The insurer can’t observe your ex post behavior, but would like to structure the transaction so you don’t take those risks that would cost the insurer more money. Here the deductible also provides a mechanism to reduce your incentive to drive quickly, because if you do you bear more of the cost. In 1975 Sam Peltzman wrote about the unexpected negative consequences of devices such as seat belts and athletic helmets as examples of moral hazard, and Gordon Tullock famously said that to negate moral hazard all steering wheels should come equipped with a big spike facing the driver.
The most salient recent application of information theory and moral hazard has been to analyzing the sub-prime mortgage derivatives, the creation and trading and insuring of those derivatives by financial institutions and insurance companies, and the resulting financial crisis of 2008.
Of course it’s overly simplistic to label asymmetric information a “market failure” and advocate regulation without exploring the institutional alternatives that people come up with to reduce its costs. Insurance deductibles are an example, as are warranties on used cars. More simply, individuals can keep a detailed record of car maintenance receipts (itself a costly activity, but can be cheaper than the reduction in sales price when you want to sell the car). New businesses also emerge to reduce information asymmetry — this validation of vehicle quality is the core of Carmax‘s business. Digital technology has also created myriad reputation-based mechanisms for mitigating information asymmetries, which is one way of thinking about how the “sharing economy” creates value that didn’t exist before.