Harvard Business School Asymmetric Information: Market Failures, Market Distortions, and Market Solutions

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1 Harvard Business School Asymmetric Information: Market Failures, Market Distortions, and Market Solutions March 27, 1997 Throughout our analysis of markets, we have implicitly focused on situations of symmetric information buyers and suppliers are equally well informed about the transaction they are thinking of making. Typically, we have discussed situations of perfect information, in which both buyers and suppliers know precisely the characteristics of the good or service that may be bought or sold; there is little ambiguity, for example, in the definition of a vacation package to a particular Florida resort on a particular weekend, with air transportation from Boston on a given airline. In such situations, buyers and suppliers can calculate their respective willingnesses to pay and accept for this well-defined good or service. When buyers and suppliers are allowed to trade freely, we expect all gainful trades all trades in which the willingness-to-pay (wtp) exceeds the willingness-to-accept (wta) to be realized. We have termed such an outcome efficient, since it ensures that total economic surplus is maximized. Clearly, buyers and sellers do not actually have perfect information about most transactions in which they participate. A buyer s willingness-to-pay for the trip to Florida might depend on what the weather will be like during the specified weekend, which is not known at the time the vacation is purchased. However, since neither the buyer nor the seller has superior information about the future weather, information is symmetric, though not perfect. The presence of symmetric but imperfect information does not significantly alter the economic analysis of a market. In some sense, the uncertainty or randomness just becomes one more commonly known aspect of the description of the good to be traded: the vacation package is now a trip to Florida on a weekend that historically has a 70% chance of being sunny, for example. While this might affect buyers willingness-to-pay (and might even affect different buyers differently), it does not change the fact that we would expect all gainful trades to be made. The situation is much more complicated when information is imperfect and asymmetric. In that case, one participant to a transaction either a buyer or a seller has an informational advantage over the other party. How does this affect the outcome of free trade among buyers and sellers? As we shall see, asymmetric information may lead to a market failure, in the sense that not all gainful trades are made; when this happens, total economic surplus is not maximized, and the market outcome is therefore inefficient. Further, even when there is not a failure of the market, one party s informational advantage may distort the market outcome, altering the division of the economic surplus between the buyer and the supplier. Q1. In what kinds of industries are informational advantages likely to be most important? Assistant Professor Kenneth S. Corts prepared this note as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright 1997 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call or write Harvard Business School Publishing, Boston, MA No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School. 1

2 Asymmetric Information: Market Failures, Market Distortions, and Market Solutions 2 A seller s informational advantage: the market for lemons When might a seller have superior information regarding a good or service to be traded? In some cases, the quality of a product may be unknown. While a consumer can verify a product s technical specifications, subtler features of product quality, as well as the product s durability and reliability, may be difficult to ascertain prior to purchase. Consumers are likely to be poor interpreters of information in certain markets for technologically complex products, for example even when data is abundant. For other products, information may be scarce, especially early in a product s life. For still other products, comprehensive and detailed information might be available, in principle, to a motivated, intelligent, and patient buyer, but some consumers will not devote the effort to collect that information, either out of sloth or because the magnitude of the purchase doesn t warrant the investment. When consumers have less information about a product than its seller does, the market is characterized by asymmetric information. The study of such markets is concerned with how this affects the willingness of consumers to pay for these products, and how it affects the corresponding supply decisions of potential sellers. Perhaps the most interesting examples of asymmetric information are situations where information is private, so that there simply is no way for a buyer to become fully informed about a product at any expense or with any amount of research. Private information is prevalent in financial markets. Imagine the founders of a startup firm considering the possibility of selling shares in their company to raise cash for a proposed project. They are likely to have private knowledge of the project s prospects that is beyond what the financial markets and potential investors can determine. If several firms with projects of varying viability approach the capital markets, the following problem arises: At any given price for new shares (at any given multiple, say), only the most pessimistic managers will find selling shares attractive. That multiple will seem too low to managers with the best projects, who are not eager to dissipate their claim to (what they anticipate to be large) future cash flows. Knowing this, the capital markets will be suspicious of anyone eager to sell shares: What kinds of managers are eager to sell off their stake in their companies? What does that say about their confidence in their proposed project? The labor market is another interesting example of a market where private information is prevalent. Workers the sellers of labor are significantly better informed about their abilities, their experiences, their work ethic, and so on than an employer can ever hope to become, even with the most comprehensive interviewing process. In this situation, the study of markets with asymmetric information is concerned with how this informational disadvantage affects the employer s assessment of prospective employees abilities and how this uncertainty about their abilities affects its willingness to hire them at a given salary. We will work through the principles of this analysis by using the economist s classic example of asymmetric information: the market for used cars. Suppose that in the market for a specific type of used car there are good cars and lemons (i.e., cars that their owners know are unreliable or prone to breaking down). Good cars are worth $3000 to buyers and $2500 to sellers; lemons are worth $2000 to buyers and $1500 to sellers. Suppose also that there are more potential buyers than sellers, so that every car on the market should be sold; total surplus is maximized when all cars are sold because buyers wtp for each kind of car exceeds the sellers wta. Further, this imbalance in the market suggests that competition among buyers to purchase a particular car drives the market price up to their willingness to pay; because suppliers of cars are relatively scarce they are in a strong bargaining position and should capture the full surplus generated by each transaction. If a buyer can ascertain the quality of a car whether it is a lemon simply by inspecting the car and quizzing its owner about its performance, then this is a market of perfect information that should function in the standard way. All cars would be sold; good cars would sell for $3000 and

3 Asymmetric Information: Market Failures, Market Distortions, and Market Solutions lemons would sell for $2000. Buyers obtain no surplus from the transactions, and every seller earns a profit or surplus of $500. This market outcome is efficient in the sense that total social surplus is maximized. How does asymmetric information about quality affect the functioning of this market? Suppose that 70% of the cars are lemons and 30% of the cars are good. If all cars remain on the market, then a buyer s expected or average valuation of a car is 0.3*(3000) + 0.7*(2000) = $2300. This is the most that a buyer, wary of the possibility of purchasing a lemon, will pay for a car of unknown quality. But at $2300, who will want to sell their cars? The owner of a lemon would be glad to sell at $2300, capturing a surplus of $800 over their wta of $1500. Owners of good cars, who value their cars at $2500, prefer to keep their cars than to sell them for that price. So, the quality of products on the market is endogenous; potential sellers supply decisions respond to the market price. Consumers can therefore infer that any car on the market at less than $2500 is a lemon; there is no asymmetric information about quality at this price in the sense that every buyer knows that anyone willing to sell for less than $2500 must have only a lemon to offer. Knowing that only lemons would be sold for $2300, no consumer is willing to pay more than $2000 for a car on the market at that price, since it must be a lemon. As a result, only lemons are sold; because the sellers have all the bargaining power, lemons trade at $2000 in this example. Q2. Is there a market failure? In what sense? Who benefits from the informational asymmetry? Who is harmed? What happens if the lemons problem is less severe, in the sense that a smaller proportion of all cars are lemons? If the proportions are reversed, so that 70% of cars are good and 30% are lemons, then a buyer s expected valuation of a car of unknown quality is.7(3000)+.3(2000)=$2700. At that price, all sellers even those of high-quality cars are willing to part with their cars. How does this change the equilibrium outcome? Q3. Is there a market failure? Do any trades take place? Of which type(s) of cars? At what price? Do the buyers care that they are disadvantaged informationally? Do the sellers benefit from their information advantage? Solving the lemons problem: credible signals of quality How might the informational asymmetry inherent to the lemons problem be resolved? It is clear that the consumer has an incentive to become informed about the quality of the product if it is possible to do so at a reasonable expense: such a consumer could avoid overpaying for a low-quality car or could confidently pay a high-quality price for a car determined to be of high quality. For this reason, many consumers in the used car market do in fact try to become better informed, perhaps by taking the car to a mechanic for an evaluation of its condition. In the case of new cars or other bigticket items, consumers gather more information through Consumer Reports and similar sources that serve as information-gathering intermediaries. Other potential solutions to this informational problem include the establishment of government regulations requiring certain disclosures about product quality and performance. While such methods of improving information may work in some circumstances, they are necessarily inadequate when it comes to truly private information. No government rule or 3

4 Asymmetric Information: Market Failures, Market Distortions, and Market Solutions mechanic s inspection will ever really determine just how hard a used car has been driven or just how likely it is to fail to start on rainy mornings. The devices of the consumer for improving his or her information are inherently limited. But, the consumer is not the only party that benefits from eliminating asymmetric information; the sellers of high-quality products also benefit from convincing consumers of the quality of their products. What can a high-quality firm do to resolve this informational asymmetry? Simple claims of high product quality are likely to seem hollow to consumers; low-quality firms clearly have the incentive to claim to be high quality, and truth-in-advertising laws are helpless in eliminating such false claims when information about quality is truly private and unverifiable. How then might the seller of a high-quality product convince (skeptical) buyers that its product is in fact high quality? One solution involves what economists call signaling. If a firm can undertake some action to signal its product s quality in a credible way, then consumers can correctly identify high- and lowquality products by whether the firm undertakes that signal. It is of central importance that this signal is credible, i.e., that it is correctly believed by consumers to identify high-quality firms. Of course, low-quality firms are eager to mimic these signals of quality; however, if a signal is more costly for a low-quality firm than for a high-quality firm, then it may be possible for this action to serve as a credible signal. A simple example of such a signal is a product guarantee. Since it is more costly for a lowquality firm to offer a guarantee (more items will be faulty and must be replaced or repaired) than for a high-quality firm, offering a guarantee may be a credible signal of product quality. If good used cars never broke down, offering a guarantee would be costless to the sellers of good cars in the example above. If lemons did break down with some frequency, then offering a guarantee would be costly to the sellers of lemons (the expected cost would be the probability of breakdown times the cost of repairs). If this cost exceeded the benefit of posing as a seller of a good car by offering a guarantee, then no seller of a lemon would offer a guarantee. Hence, consumers would correctly infer that all cars with guarantees were good cars, and the guarantee would serve as a credible signal of product quality. We will work through the logic of signaling with an example from one of the primary illustration of markets with asymmetric information: the labor market. Suppose that there are two types of workers: good and bad. Each worker knows whether he or she is a good worker, but there is no way for a prospective employer to determine which type a particular worker is. Good workers are worth $80K to a firm; bad workers are worth $50K. Good workers have an outside option of taking a job in some other industry for $55K; for bad workers this alternative pays only $35K. Suppose that half the workers are good, and half are bad, and that workers are in short supply so that competition among employers drives the market wage up to the true (expected) value of the employee. 4 Q4. Who is hired? At what wage? Is there a market failure? Who benefits from the presence of asymmetric information? Who is harmed? How might the good workers signal that they are in fact good workers? A classic example of a signal of employee quality is education. Suppose (perhaps hypothetically) that students learn nothing that contributes to their productivity in business school. For $25K a good worker can apply to, attend, and graduate from a prestigious business school. A bad worker, inherently less intelligent and motivated, must spend an extra $10K (on GMAT prep courses to get admitted, on tutors while in school, in psychic costs of working twice as hard, etc.) in order to acquire the same degree. Since

5 Asymmetric Information: Market Failures, Market Distortions, and Market Solutions undertaking this signal obtaining the degree is more costly for a bad worker than for a good worker, this signal may satisfy the requirement for credibility. Q5. If employers believe that education is a signal of worker quality, then they will assume that only those workers with degrees are of high quality. In this case, what is the monetary benefit to a worker associated with obtaining a degree? Which set(s) of workers choose to get a business degree under these circumstances? Is this signal credible? Who is hired? At what wage? If the government offered everyone a $10K grant towards business school, what levels of education and what wages would prevail? A buyer s informational advantage: market failure and its resolution through screening The above examples of markets for products of unknown quality, and of equity and labor markets all involved informational asymmetries in which sellers had superior information. It is unlikely that a buyer would ever have superior information about a seller s product: could a buyer ever know the history of a used car better than its owner does? Could any amount of interviewing and testing ever determine a potential employee s trustworthiness beyond that person s selfknowledge? This seems unlikely. However, there are other circumstances in which buyers are likely to be better-informed not about the seller s product, but about themselves in a way that affects the value of the transaction to either the buyer or the seller. This information might take one of two forms: information about the buyer s willingness to pay, or information about what it will cost the seller to serve that buyer. In the example of the Florida trip, there might be asymmetric information about a buyer s desire to travel on a particular weekend. Perhaps some buyers are eager to travel on the specified date; their demanding business school curriculum will not permit travel on any other weekend in the coming months. Others enjoy a more flexible schedule and could travel on many alternative weekends; their willingness-to-pay for a trip on that specific weekend is therefore tempered by the availability of alternative vacation plans. Would anyone care if a buyer had this kind of superior information? At first glance, it seems not. While every buyer in the lemons example is concerned about the possibility of buying a lemon, a seller of a trip doesn t necessarily care whether a particular buyer that he or she faces has a high wtp or not. If trips are in short supply relative to potential vacationers, then the seller of a trip can simply demand a price equal to the higher group s wtp. Although it would certainly be inefficient for a trip to be sold to a low wtp buyer, by setting price at the high wtp buyer s willingness-to-pay, the seller does not run the risk of accidentally selling to a low-wtp buyer. None of the potential buyers with a lower willingness-to-pay will be interested in the trip at that price, and the seller is perfectly happy to sell only to the high wtp group. What if trips available for sale are more numerous, however, outnumbering the buyers in the high group? If the willingness-to-accept for trips is lower than even the low group s wtp, the efficient outcome requires that the low wtp group buys the vacation too. But, that would require that the seller price the trip well below the higher group s wtp. What is the informationally disadvantaged seller to do? To make things concrete, assume that a single seller can put together 7 trips at $900 each. There are five buyers with wtp of $1200 and five buyers with a wtp of $1000. If restricted to setting a single price, what price should the seller charge? At $1200, five trips are sold for a profit of 5*(1200-5

6 Asymmetric Information: Market Failures, Market Distortions, and Market Solutions 900)=$1500. At $1000, seven trips are sold for a profit of 7*( )=$700. It makes sense to stick with the higher price, even though this means that gainful trades are not made. Social surplus is not maximized because there are buyers with wtp higher than the seller s wta who do not buy the trip at equilibrium prices. Again, asymmetric information causes a market failure. Not only does this fail to maximize social surplus, it fails to maximize firm profits since the $800 of unachieved potential surplus is also potential profit for the seller. If the seller could resolve the asymmetric information to figure out who the low wtp buyers are, then the seller could offer them a special discounted fare of $1000 while charging the full $1200 to the high wtp group. This would lead to the maximization of social surplus and increase the seller s profits by $800. The practice of charging different prices to different consumers is known as price discrimination. The process of separating consumers into distinct groups that vary in some important, but unobservable way is what economists call screening. The problem with attempting to screen consumers in the presence of asymmetric information is that the high wtp buyers will tend to pose as low wtp buyers, just as low-quality firms want to mimic the high-quality firms when it comes to signaling product quality. Q6. When might the different types of buyers for this trip be identifiable, so that there is no asymmetric information and screening is straightforward? In this example, what kinds of schemes might induce buyers to reveal their willingness-to-pay even when types are not directly identifiable? 6 In particular, what role might advance purchase requirements play in this context? So, sellers might care about a buyer s superior information when it affects the willingness-topay? What other kinds of information might a buyer have that a seller would like to know? In some industries, the characteristics of a buyer determine how expensive it is to produce the good in question. Health care and insurance markets are a primary example. If the good that is sold is not some specific medical procedure, but rather the coverage of conventional treatments for whatever maladies might arise, then a buyer s private information about his or her health status and likelihood of major illness is of significant interest to the seller of the coverage. As when attempting to price discriminate, a firm might wish to screen its consumers. In this case, that might be accomplished by designing a health care plan that is particularly attractive to people who are likely to be healthier than average (and therefore more profitable customers), perhaps by tailoring the benefits of the plan to the needs of younger consumers. Conclusion Market efficiency arguments depend heavily on many assumptions that are seldom made explicit. The assumption of symmetric information is one of the most important of these assumptions, and one of the most frequently violated. Clearly, sellers often have superior information about product quality. Consumer uncertainty and confusion over product quality can lead to market failures and distortions that are extremely costly to high-quality firms: If consumers are unsure of product quality, they will require a discount from their full willingness-to-pay to compensate them for the risk they run of buying an inferior product. This limits the high-quality firm s ability to capture the value created by its product, which always leads to reduced profits and sometimes to a complete breakdown for high-quality goods. Overcoming such market failure through credible signals of quality can correct that situation and improve the profits of a high-quality firm. At the same time, buyers often have superior information about their willingness-to-pay for a product or about personal characteristics that affect their profitability as customers to some seller. A seller can increase the share of total value that it captures through price discrimination, which often

7 Asymmetric Information: Market Failures, Market Distortions, and Market Solutions requires screening consumers somehow inducing them to purchase the given product at different prices. If a firm is not alert to this asymmetric information and sets a single price for all consumers, one of two things may happen: gainful trades go unconsummated and value creation is not maximized; or the trades that are made take place at a price well below some consumers wtp, failing to maximize the firm s share of the surplus created. In other cases, the buyers superior information concerns the cost of serving them. Ignoring this can mean allowing competitors to pick off the most profitable customers, leaving your firm to serve the most costly consumers. Much as signaling a product s quality can overcome the failures associated with sellers having superior information, screening consumers through careful product design, pricing, and advertising can improve the profits of a firm that is at an informational disadvantage. 7