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Asymmetric Information 16

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There’s a good chance you’ve been in the market for a used car (and if you haven’t yet, you probably will be soon!). People buy over 35 million used cars and small trucks in the United States each year, well more than double the number of new vehicles they buy.1 And all of those millions of buyers are concerned about the quality of the cars they look at. If you buy from an individual seller, you may wonder why he’s selling his car. If you buy from a dealer, you may wonder if it was a rental car, abused by a series of uncaring, non-owning drivers who drove it over railroad tracks at 60 miles per hour, or if it was repossessed from an owner who couldn’t afford to make the payments, much less keep up with its maintenance.

The analyses we’ve done to this point don’t fully capture the economics of situations like this. That’s because in the topics we’ve analyzed so far, we assumed that economic decision makers have all the relevant information about the markets in which they operate. Consumers know all the attributes of the goods they are buying and how intensively they will use them. Firms know their marginal costs, how hard their employees will work, how talented they are at their jobs, and so on. That is, we’ve described markets with complete information—all market participants know everything important for making economic decisions.

In the real world, however, information is neither free nor commonly shared among all parties in a transaction. Economists have an extra set of tools to understand what happens in these types of situations, and in this chapter we use them to look at markets in which one party knows more than the other about the goods or services being traded. Economists’ term for this imbalance in knowledge is asymmetric information.2

Asymmetric information can have a profound impact on markets—an impact that is, from a social standpoint, quite negative. If the information gaps are large enough, in fact, it is theoretically possible for a market to completely shut down even if everyone could benefit from trade if it occurred. Interestingly, the people who suffer from such market failure include not only those with an information disadvantage, but also those who hold the extra information. We’ll explain why below. Given that asymmetric information can destroy the large gains in consumer and producer surplus that occur in markets, it’s not surprising that many institutions have arisen to lessen such effects. We talk about these institutions in this chapter as well.

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