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Your authors flew to New York for a meeting with Macmillan Education, the publisher of this textbook. We arrived at the airport and jumped in a cab to take us to Madison Avenue (home of many publishers and advertisers, hence the term “Mad Men”). As the car moved through New York, Tyler asked the driver why we weren’t taking the usual route. “Traffic,” the driver answered. Uh-huh. When we arrived at 41 Madison, the bill was noticeably larger than usual. Had we been taken for a ride? Hard to say, maybe there was traffic on Harlem River Drive. We let it go, as Macmillan was paying the bill anyway. (Did the driver also suspect we would be reimbursed?) On the 37th floor, our publisher greeted us: “We need a new chapter for the third edition, something important with real world relevance. What is it going to be?” We answered in unison, “asymmetric information.”

Asymmetric information is when one party to an exchange has more or better information than the other party. Taxi drivers often do have better information than their customers about traffic, and so it sometimes makes sense to defer to their judgment about the best route. On the other hand, our driver might have figured that two out-of-towners going to a business meeting might not recognize (or care) that he was jacking up the bill. We can’t be sure, and that is why the taxi driver’s ploy worked, if indeed it was a ploy.

One clever team of economists decided to test how often taxi drivers use their information advantage for their own gain. The economists arranged for similar people to take a cab ride from an airport to a hotel. Each rider carried a GPS unit to precisely track the time and distance the cab traveled and they left the airport just minutes apart, so traffic conditions were the same. After nearly 350 trips and thousands of miles traveled, the economists found that half the passengers were taken on detours that lengthened the ride by about 10%. OK, but maybe the taxi drivers simply didn’t know the shortest route. That’s why the most important part of the experiment was that some of the passengers were trained to appear to be from out-of-town while others were trained to appear as locals. The economists found that detouring wasn’t random: Passengers who appeared to be from out-of-town were detoured more often. The taxi drivers were taking the longest detours when their information advantage appeared to be the greatest.1

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Problems of asymmetric information aren’t limited to cab rides. In many markets, the seller of a service is also the expert who diagnoses how much service is needed. We rely, for example, on physicians, auto mechanics, and dentists to fix problems and also to tell us what the problem is. If the auto mechanic tells you that you need a Johnson rod, well, maybe you do and maybe you don’t—it’s hard for a nonexpert to tell. We often buy products or services for which it’s difficult to estimate the quality. Is that used car a lemon or a plum? Firms must also estimate the quality of their potential employees and sometimes even of their customers. Out of all these applicants for the job, which one is the best? Out of all these potential buyers of health insurance, which are likely to be healthiest?

More generally, economists call these problems, principal-agent problems. How can a principal incentivize an agent to work in the principal’s interest even when the agent has information that the principal does not? The problem applies not just to buyers and sellers but to employers and employees (see more in Chapter 18), to voters and politicians (Chapter 20), and even to dating and the animal kingdom (this chapter!).

Markets work best when traders know exactly what is being traded. When that is the case, markets will attract both buyers and sellers because each side expects trade to be mutually profitable. But when one party to a (potential) trade has more or better information than the other party, the less informed party may withdraw from the market and decide that trade is too risky or not in his or her interest. In extreme cases, asymmetric information can mean that markets fail to exist.

In Chapter 10 we saw that markets may not be ideal when there are significant effects on bystanders. In one sense, asymmetric information is a more severe challenge to markets than externalities because problems of asymmetric information mean that markets may not work well even for buyers and sellers! In another way, the problem is less severe. Buyers and sellers don’t have an incentive to solve externality problems but buyers and sellers do have an incentive to solve problems of asymmetric information so they can complete mutually profitable trades. As we will see, market institutions, as well as laws and regulations, have evolved to deal with problems of asymmetric information. To understand the solutions, however, we must first understand the problem.

Let’s begin with the problem of moral hazard.