Welcome to our series on economic theories that are changing the way we think. Today, Richard Holden explains how asymmetric information – when one party to a transaction knows more about the deal than the other – affects everything from car sales and IPOs, to credit costs and tattoos.

You may not consider yourself an economist but you almost certainly have first hand experience of an aspect of economic theory called asymmetric information.

In short, it’s when one party to a transaction knows more than the other about the deal underway.

Suppose you are interested in buying a used car. You scour the classifieds and find just the car you want, and it’s right in your price range. You meet the seller, who seems nice, and you buy it. On the drive home it breaks down. You have no warranty, no recourse, and are pretty annoyed. What happened?

Well, the seller, of course, knew a lot more about the car than you did. He knew whether the engine was regularly over-revved, regular maintenance had been performed, if it had been garaged.

Now, this is a sad story for our poor car buyer but from an economist’s perspective it could have been worse. After all, there was trade.

An economist’s real nightmare is when markets break down altogether.

Goodies and baddies

In a famous paper in 1970 titled The Market for Lemons, the Nobel Prize-winning American economist George Akerlof pointed out how this kind of asymmetric information – where one party to a potential transaction is better informed than the other party – can lead markets to fall apart completely.

Here’s the logic. Suppose there are two types of sellers: good types and bad types. Good types have good quality cars, say, and bad types have bad ones. And suppose that there are equal numbers of good and bad types. If the car is a good type, buyers are willing to buy. If it is a bad type, they are not. What happens in this market?

To answer that question, we need to use to logic of equilibrium and think not only about buyers and sellers valuations, but about their beliefs.

So, suppose that there is market in which both good and bad types sell their cars. What will buyers believe about the quality of the car they are getting? They will think that there is a 50% chance it is good quality and a 50% chance that it is bad quality. So they will value it halfway between how they value a high quality car and a low quality car. And that will be the market clearing price.

Low quality sellers are happy with this – they are getting more than their dud car is worth. But high quality sellers are not happy – they are getting less than their car is worth to them. Why would you sell something for less than you value it at? You wouldn’t, so the high quality sellers don’t sell. They exit the market.

Our hypothetical market is now comprised solely of low quality sellers. This is the phenomenon known as “adverse selection”: the participants in the market are the bad types.

Realising this, buyers are no longer willing to pay the intermediate price. That would be crazy. So we are left with a market of low quality potential sellers, and buyers unwilling to trade. The market has completely unravelled.

The economist’s worst nightmare has occurred: there are gains from trade (buyers want to buy high quality cars) but they go unexploited because of asymmetric information.

What to do? One thing that sellers could do is offer a warranty. That way, if the car turns out to be low quality, the buyer get her money back. No low quality seller would offer such a warranty, so the adverse selection phenomenon is reversed – only high quality cars are offered in the market. It’s hard for an individual to do that, but big car dealerships can credibly do so. And that’s exactly what we see in the world.

Asymmetric information in the real world

This idea explains a whole lot more than car dealerships, which are just a foil for the thought experiment.

Why is credit so expensive, and often under-provided, in developing economies? Why do minorities often pay higher interest rates? In both cases, it is because they often know a lot more about their ability to repay than the lender does.

Why is it hard for some companies to undertake Initial Public Offerings (IPOs)? It is because the existing owners or management know more about the prospects of the company than the public markets do.

Of course, humans adapt.

Akerlof’s fellow Nobel Laureates, Americans Michael Spence and Joseph Stiglitz, asked how the informed and uninformed parties, respectively, might improve their outcome.

Spence showed how an informed party can improve her outcome through costly “signaling” (telling or showing buyers that her product is good quality). Stiglitz and fellow American Michael Rothschild showed how the uninformed party can improve her outcome through “screening” (sifting through clues to determine quality).

These even help us understand why people seek education, get tattoos, go to church and why firms pay dividends or insurance companies offer multiple levels of cover.

They’re all forms of signalling that send messages about a person, firm or product at the heart of a transaction. They’re messages that others can “screen” to make decisions about transactions involving those people, firms or products.

In fact, once you start thinking about it, it’s hard to imagine any economic activity in which one party doesn’t know more than the other. And this usually has an impact on the nature of market activity, changing the way we interact with the world.

Richard Holden is an ARC Future Fellow.