Markets and Information Asymmetry (Andy Terry Expert Advice)

If we care about the efficient allocation of resources, we care about market efficiency. In finance, market efficiency occurs when asset prices fully reflect all available information.

For example, when Enron’s stock price notoriously failed to reflect valuable information, including the fact that insiders and management were self-dealing, the company was allocated too much capital. Meanwhile, buyers without that crucial information, including many employees, were irreparably harmed.

Similarly, consumers of products and services are most at risk, and sellers most able to benefit, when the wedge between what the seller knows and what the consumer knows about a given product — called information asymmetry — is highest. In George Akerlof’s seminal paper “The Market for Lemons,” he noted that markets can fail when information asymmetry is too high.

Sellers of products generally know more about the true value of the product than buyers. The used car market is a classic example.

Sellers of used cars know the true condition of the car, specifically, whether it’s a “lemon,” whereas potential buyers do not. Absent some sort of certification or third-party “audit” of the car, potential buyers may discount the price they are willing to pay so much that sellers of good used cars become unwilling to sell at that price, leaving only sellers of “lemons,” and the market fails.

The consumer is left with three choices. First, the consumer can greatly discount the price or abstain from the market, leading to a condition known as market failure. Second, the consumer can trust the seller, no questions asked. Finally, the consumer can rely on third-party certifications.

In fact, consumers do all of these things. Market failure has already been discussed. Trust is a significant factor in consumer decisions. Information asymmetry is very high with services, such as legal, medical, accounting, car repair and financial, and consumers must trust their service professionals.

In economics we call this trust attribute “reputation capital,” and in the product markets we label it “brand name” (Coke, Apple, Mercedes, the Big Four accounting firms). Good reputations, of any kind, are difficult to build and easy to destroy. Once destroyed, regaining trust is very difficult.

Third-party certification is the other way to deal with information asymmetry. There are many examples of third-party certification in the financial world.

Companies have their financial statements audited by auditing firms that attach their reputations to the audit report. Corporate and government bond issuers have their bonds rated by independent third parties (S&P, Moody’s). The SEC determines whether companies issuing securities to the public for the first time in initial public offerings have provided adequate disclosure.

Foreign governments and many domestic purchasers, for example, relied on the rating agencies’ certifications to purchase ultimately toxic mortgage-backed assets.

In the product and service domains, pharmaceutical companies obtain FDA approval for their drugs. In the service world most service professionals are licensed, credentialed or certified. Frequently, certification is not enough, however, so consumers also rely on reputation or obtain references.

Information asymmetry will remain. The key is what to do about it. As a consumer, the best approach is a healthy dose of skepticism. The greater the information asymmetry in a market, the more the consumer should ask the questions, “Why is the seller so willing to sell to me at this price?” and “Is the seller simply being altruistic, or does he know more about the true value of the product than I do?” n

Andy Terry is a professor of finance at the University of Arkansas at Little Rock’s College of Business. Email him at HATerry@UALR.edu.