Saturday, May 08, 2004

Asymmetric Infromation: The story of the Dead Tulips

dead tulips

The trem asymmetric information has been much talked about lateley, especially after George Akerlof, Michael Spence and Joseph E. Stiglitz were awarded the Nobel price in Economics in 2001. The Economist defines it in this way:

When somebody knows more than somebody else. Such asymmetric information can make it difficult for the two people to do business together, which is why economists, especially those practising GAME THEORY, are interested in it. Transactions involving asymmetric (or private) information are everywhere. A government selling broadcasting licences does not know what buyers are prepared to pay for them; a lender does not know how likely a borrower is to repay; a used-car seller knows more about the quality of the car being sold than do potential buyers. This kind of asymmetry can distort people's incentives and result in significant inefficiencies.

It is true that we would probably be better off without asymmetric information. People could buy more over the internet for example and therefore save considerable amounts, only if they would trust the other party. The same goes for used cars and many other things. We have all passed by good buys due to lack of trust, as well as buying lemons. Of course the world will never be without asymmetric information. God almighty would not only have to remove all dishonesty from the human race, but he would also have to remove all the information and knowledge as well.

The story below is how I first learned about asymmetric information:

Giorgio Inzerilli went to the flower market on his first day in Netherlands. There he saw the most beautiful set of tulips he had ever seen. Nothing close to that he had ever seen in his native Torino. And the price. Simply ridiculously low. He bought the tulips and placed them in the window of his apartment. The next day, much to his surprise, all of the flowers had died.

This little story shows us few things about asymmetric information. Not only does it show (and everyone can probably remember many similar events in his own life) that it is part of everyday life and we are either the ones that have more or less information than the other party.

We also see that the price of the flowers reflects the asymmetric information in that particular situation. The lady with the flowers knows that people don't trust her as much as a respected flower retailer. And what happens to the price, it goes down of course. The next day she might have new batch of flowers that would last the week, but the price would not go up. No one would trust her any more the next day; the market attempts to solve this problem by lowering the price the price of goods due to the uncertainity in the situation.

In most instances the market (society if you will) has attempted to solve these problems, often with quite good results . For example when I was buying a car last fall I could take the car to a repair shop for a detailed check before the purchase (very cheap actually). I could also get a good feel for the market by browsing the market on the net. Some entrepreneurs managed to sign up all of the car dealers in the region. This is a pure market driven solution that gives the buyer a valuable tool to explore the market and therefore reduce the 'information gap'. This is just a everyday example how the market solves the problem and there is no need for institutions to "to counteract the effects of quality uncertainty" as George A. Akerlof would have liked us to believe.

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