Information Asymmetry

From the Economist Schools Brief

 IN 2007 the state of Washington introduced a new rule aimed at making the labour market fairer: firms were banned from checking job applicants’ credit scores. Campaigners celebrated the new law as a step towards equality—an applicant with a low credit score is much more likely to be poor, black or young. Since then, ten other states have followed suit. But when Robert Clifford and Daniel Shoag, two economists, recently studied the bans, they found that the laws left blacks and the young with fewer jobs, not more.

Before 1970, economists would not have found much in their discipline to help them mull this puzzle. Indeed, they did not think very hard about the role of information at all. In the labour market, for example, the textbooks mostly assumed that employers know the productivity of their workers—or potential workers—and, thanks to competition, pay them for exactly the value of what they produce.

You might think that research upending that conclusion would immediately be celebrated as an important breakthrough. Yet when, in the late 1960s, George Akerlof wrote “The Market for Lemons”, which did just that, and later won its author a Nobel prize, the paper was rejected by three leading journals. At the time, Mr Akerlof was an assistant professor at the University of California, Berkeley; he had only completed his PhD, at MIT, in 1966. Perhaps as a result, the American Economic Review thought his paper’s insights trivial. The Review of Economic Studies agreed. The Journal of Political Economy had almost the opposite concern: it could not stomach the paper’s implications. Mr Akerlof, now an emeritus professor at Berkeley and married to Janet Yellen, the chairman of the Federal Reserve, recalls the editor’s complaint: “If this is correct, economics would be different.”

In a way, the editors were all right. Mr Akerlof’s idea, eventually published in the Quarterly Journal of Economics in 1970, was at once simple and revolutionary. Suppose buyers in the used-car market value good cars—“peaches”—at $1,000, and sellers at slightly less. A malfunctioning used car—a “lemon”—is worth only $500 to buyers (and, again, slightly less to sellers). If buyers can tell lemons and peaches apart, trade in both will flourish. In reality, buyers might struggle to tell the difference: scratches can be touched up, engine problems left undisclosed, even odometers tampered with.

To account for the risk that a car is a lemon, buyers cut their offers. They might be willing to pay, say, $750 for a car they perceive as having an even chance of being a lemon or a peach. But dealers who know for sure they have a peach will reject such an offer. As a result, the buyers face “adverse selection”: the only sellers who will be prepared to accept $750 will be those who know they are offloading a lemon.

Smart buyers can foresee this problem. Knowing they will only ever be sold a lemon, they offer only $500. Sellers of lemons end up with the same price as they would have done were there no ambiguity. But peaches stay in the garage. This is a tragedy: there are buyers who would happily pay the asking-price for a peach, if only they could be sure of the car’s quality. This “information asymmetry” between buyers and sellers kills the market.

Is it really true that you can win a Nobel prize just for observing that some people in markets know more than others? That was the question one journalist asked of Michael Spence, who, along with Mr Akerlof and Joseph Stiglitz, was a joint recipient of the 2001 Nobel award for their work on information asymmetry. His incredulity was understandable. The lemons paper was not even an accurate description of the used-car market: clearly not every used car sold is a dud. And insurers had long recognised that their customers might be the best judges of what risks they faced, and that those keenest to buy insurance were probably the riskiest bets.

Yet the idea was new to mainstream economists, who quickly realised that it made many of their models redundant. Further breakthroughs soon followed, as researchers examined how the asymmetry problem could be solved. Mr Spence’s flagship contribution was a 1973 paper called “Job Market Signalling” that looked at the labour market. Employers may struggle to tell which job candidates are best. Mr Spence showed that top workers might signal their talents to firms by collecting gongs, like college degrees. Crucially, this only works if the signal is credible: if low-productivity workers found it easy to get a degree, then they could masquerade as clever types.

This idea turns conventional wisdom on its head. Education is usually thought to benefit society by making workers more productive. If it is merely a signal of talent, the returns to investment in education flow to the students, who earn a higher wage at the expense of the less able, and perhaps to universities, but not to society at large. One disciple of the idea, Bryan Caplan of George Mason University, is currently penning a book entitled “The Case Against Education”. (Mr Spence himself regrets that others took his theory as a literal description of the world.)

Signalling helps explain what happened when Washington and those other states stopped firms from obtaining job-applicants’ credit scores. Credit history is a credible signal: it is hard to fake, and, presumably, those with good credit scores are more likely to make good employees than those who default on their debts. Messrs Clifford and Shoag found that when firms could no longer access credit scores, they put more weight on other signals, like education and experience. Because these are rarer among disadvantaged groups, it became harder, not easier, for them to convince employers of their worth.

Signalling explains all kinds of behaviour. Firms pay dividends to their shareholders, who must pay income tax on the payouts. Surely it would be better if they retained their earnings, boosting their share prices, and thus delivering their shareholders lightly taxed capital gains? Signalling solves the mystery: paying a dividend is a sign of strength, showing that a firm feels no need to hoard cash. By the same token, why might a restaurant deliberately locate in an area with high rents? It signals to potential customers that it believes its good food will bring it success.

Signalling is not the only way to overcome the lemons problem. In a 1976 paper Mr Stiglitz and Michael Rothschild, another economist, showed how insurers might “screen” their customers. The essence of screening is to offer deals which would only ever attract one type of punter.

Suppose a car insurer faces two different types of customer, high-risk and low-risk. They cannot tell these groups apart; only the customer knows whether he is a safe driver. Messrs Rothschild and Stiglitz showed that, in a competitive market, insurers cannot profitably offer the same deal to both groups. If they did, the premiums of safe drivers would subsidise payouts to reckless ones. A rival could offer a deal with slightly lower premiums, and slightly less coverage, which would peel away only safe drivers because risky ones prefer to stay fully insured. The firm, left only with bad risks, would make a loss. (Some worried a related problem would afflict Obamacare, which forbids American health insurers from discriminating against customers who are already unwell: if the resulting high premiums were to deter healthy, young customers from signing up, firms might have to raise premiums further, driving more healthy customers away in a so-called “death spiral”.)

The car insurer must offer two deals, making sure that each attracts only the customers it is designed for. The trick is to offer one pricey full-insurance deal, and an alternative cheap option with a sizeable deductible. Risky drivers will balk at the deductible, knowing that there is a good chance they will end up paying it when they claim. They will fork out for expensive coverage instead. Safe drivers will tolerate the high deductible and pay a lower price for what coverage they do get.

This is not a particularly happy resolution of the problem. Good drivers are stuck with high deductibles—just as in Spence’s model of education, highly productive workers must fork out for an education in order to prove their worth. Yet screening is in play almost every time a firm offers its customers a menu of options.

Airlines, for instance, want to milk rich customers with higher prices, without driving away poorer ones. If they knew the depth of each customer’s pockets in advance, they could offer only first-class tickets to the wealthy, and better-value tickets to everyone else. But because they must offer everyone the same options, they must nudge those who can afford it towards the pricier ticket. That means deliberately making the standard cabin uncomfortable, to ensure that the only people who slum it are those with slimmer wallets.

Hazard undercuts Eden

Adverse selection has a cousin. Insurers have long known that people who buy insurance are more likely to take risks. Someone with home insurance will check their smoke alarms less often; health insurance encourages unhealthy eating and drinking. Economists first cottoned on to this phenomenon of “moral hazard” when Kenneth Arrow wrote about it in 1963.

Moral hazard occurs when incentives go haywire. The old economics, noted Mr Stiglitz in his Nobel-prize lecture, paid considerable lip-service to incentives, but had remarkably little to say about them. In a completely transparent world, you need not worry about incentivising someone, because you can use a contract to specify their behaviour precisely. It is when information is asymmetric and you cannot observe what they are doing (is your tradesman using cheap parts? Is your employee slacking?) that you must worry about ensuring that interests are aligned.

Such scenarios pose what are known as “principal-agent” problems. How can a principal (like a manager) get an agent (like an employee) to behave how he wants, when he cannot monitor them all the time? The simplest way to make sure that an employee works hard is to give him some or all of the profit. Hairdressers, for instance, will often rent a spot in a salon and keep their takings for themselves.

But hard work does not always guarantee success: a star analyst at a consulting firm, for example, might do stellar work pitching for a project that nonetheless goes to a rival. So, another option is to pay “efficiency wages”. Mr Stiglitz and Carl Shapiro, another economist, showed that firms might pay premium wages to make employees value their jobs more highly. This, in turn, would make them less likely to shirk their responsibilities, because they would lose more if they were caught and got fired. That insight helps to explain a fundamental puzzle in economics: when workers are unemployed but want jobs, why don’t wages fall until someone is willing to hire them? An answer is that above-market wages act as a carrot, the resulting unemployment, a stick.

And this reveals an even deeper point. Before Mr Akerlof and the other pioneers of information economics came along, the discipline assumed that in competitive markets, prices reflect marginal costs: charge above cost, and a competitor will undercut you. But in a world of information asymmetry, “good behaviour is driven by earning a surplus over what one could get elsewhere,” according to Mr Stiglitz. The wage must be higher than what a worker can get in another job, for them to want to avoid the sack; and firms must find it painful to lose customers when their product is shoddy, if they are to invest in quality. In markets with imperfect information, price cannot equal marginal cost.

The concept of information asymmetry, then, truly changed the discipline. Nearly 50 years after the lemons paper was rejected three times, its insights remain of crucial relevance to economists, and to economic policy. Just ask any young, black Washingtonian with a good credit score who wants to find a job.

25 times real life echoed The Simpsons

From The Telegraph 

1. When a lemon tree was stolen

In the 1995 Simpsons episode Lemon of Troy, the children of Springfield waged war against their Shelbyville rivals, after the latter stole a treasured lemon tree belonging to the town. But would anyone bother to steal a lemon tree in real life? Apparently, the answer is yes. In 2013, a bizarre theft took place in a suburban area of Houston, Texas, when thieves dug up and ran off with a lemon tree belonging to local resident Kae Bruney. Addressing the robbers directly, Bruney told local news channel KHOU: "I hope you find yourself stricken with dysentery on a long drive in the middle of nowhere. If you needed my lemons so bad, I hope they serve you well."

2. When a man grew a "tomacco"

Inspired by the 1999 episode in which Homer invents "tomacco", a highly addictive tomato-tobacco hybrid, Rob Baur, a Simpsons fan from Lake Oswego in Oregon, cultivated his own tomacco plants. Using a Scientific American article that outlined how to graft together a tobacco and tomato plant, Baur created a plant that produced fruit that looked like a normal tomato, but contained high levels of nicotine (enough to render it inedible and potentially very toxic). Unlike their Simpsons counterparts, Baur's tomacco plants were not eventually destroyed by a herd of marauding tobacco-addicted farm animals.

3. When a three-eyed fish was caught near a nuclear power plant

In the 1990 episode Two Cars in Every Garage and Three Eyes on Every Fish, Bart caught Blinky, a three-eyed fish, in the pond fed by Monty Burn's nuclear power plant. In 2011, a three-eyed fish was pulled from a reservoir in Argentina. Worryingly, the mutation didn't appear to be a natural one: the reservoir in question was fed by water from a nuclear plant in the province of Córdoba.

4. When a man rebelled against his parents by getting the ultimate Simpsons tattoo

Simpsons Roasting on an Open Fire, the first episode of the show to air, saw Bart rebel against Marge and sneak off to get himself a tattoo. One man who wouldn't have seen the episode at the time was 27-year-old New Zealander Lee Weir, who was banned from watching the show when growing up. (Weir describes his father as "a real-life Ned Flanders".) Like Bart, Weir subsequently rebelled against his parents by getting tattooed – with 41 images of Homer Simpson. He currently holds the world record for having the most tattoos of the same cartoon character on his body. Speaking to the Daily Mail about his record-breaking status, Weir said: "It hasn't made me a better person but I definitely think it has made me a slightly cooler one."

^{(Picture: Guinness World Records, via Twitter)}

5. When Homer's dream car became a reality

The car designed by Homer for his auto-manufacturer half-brother in the 1991 episode O Brother, Where Art Thou featured lurid green bodypaint; leashes and muzzles to restrain "fighting kids"; a bonnet ornament depicting a 10-pin bowler, giant externally mounted cup holders, and a supersized horn that blasted out La Cucaracha. For the 2013 24 Hours of Lemons race – an annual parody of the 24 Hours of Le Mans endurance race series, held in the US – Porcubimmer Motors recreated Homer's design in loving detail (right down to the La Cucaracha-blasting horn).

6. When someone invented a "real" baby translator

A "cry translator" (designed to help parents interpret the sounds produced by their babies) hit the market in 2009. The website for the device claims: "in 3 seconds it will tell you the reason for [your baby's] crying". But the Simpsons managed to get there first almost two decades earlier: in the 1992 episode Brother, Can You Spare Two Dimes?, Homer's half-brother Herb tried his hand at inventing a "baby translator", to help mothers understand their children.

7. When a Kill Bill billboard took inspiration from Itchy and Scratchy

^{The New Zealand Kill Bill billboard}

An impressive New Zealand billboard poster advertising Quentin Tarantino's Kill Bill made it appear as if blood had splattered out of the poster on to the street below, covering cars in red droplets. But, when it comes to graphic, bloody violence, it's probably fair to say that Tarantino movies have nothing on Tom and Jerry parody Itchy and Scratchy, the fictional cartoon beloved by Bart and Lisa. It's therefore not surprising that, several years before Kill Bill hit cinema, The Simpsons depicted The Itchy and Scratchy Movie being advertised via blood-spraying billboard.

^{The Simpsons' billboard for The Itchy and Scratchy Movie}

8. When Michelangelo's David was forced to cover up

Itchy and Scratchy also featured heavily in the 1990 episode Itchy and Scratchy and Marge, in which Marge led a censorship campaign, horrified by the show's violence. She later realised the censorship had gone too far, after Michelangelo's David was taken to a Springfield museum, and local citizens protested against the statue's nudity. In 2001, a Florida-based shop put a replica of Michelangelo's David outside its front door. A handful of citizens objected to the "indecent" statue and successfully campaigned to have David's private parts covered with a cloth. More recently, in 2014, an elderly British couple, Clive and Joan Burgess, received complaints from neighbours and faced an intervention from their local council, after they placed a replica of the statue in their front garden.

9. When the "Simpsons house" was built ... then de-Simpsonised

In 1997, a Fox and Pepsi-sponsored competition offered entrants a life-size replica of the Simpsons' house as its main prize. The four bedroom yellow-painted house was erected in Henderson, Nevada. Decorators had to watch over 100 episodes of The Simpsons to get the colours and furnishings just right for the eventual owner. Sadly, the winner chose a cash-prize alternative, and the house was stripped and sold in 2001.

10. When Florida launched a real life "snake whacking"

In the 1993 episode Whacking Day, Springfield's residents indulged in an annual "snake whacking", during which citizens rounded up local snakes, drove them into the town square, and beat them to death. Writer George Meyer envisaged the episode as a way to raise awareness about the mistreatment of snakes. One state who evidently didn't pick up the subtext was Florida, where wildlife officials launched the "2013 Python Challenge", a competition in which hunters competed to see who could kill the greatest number of pythons. To be fair to the Florida Florida Fish and Wildlife Conservation Commission, the idea was motivated by a need to tackle the problems caused by an explosion in the area's non-native snake population, and hunters were encouraged to kill the pythons "humanely", rather than beating them to death. But with cash prizes offered for the longest and greatest number of snakes dispatched, it's hard not to think of the Springfield "snake whacking" spirit.

11. When the Rolling Stones toured, despite being in their seventies

Lisa is given a glimpse into the future in the 1995 episode Lisa's Wedding, which was actually set in 2010. One of the episode's jokes was a poster advertising the "Rolling Stones Steel Wheelchair Tour 2010”. In real life, the Stones toured in 2005, 2012 and 2014, and are still going strong. Singer Mick Jagger is 70, as is lead guitarist Keith Richards; drummer Charlie Watts is 72, and guitarist Ronnie Wood is a comparatively sprightly 66.

12. When video phones became a reality

Lisa's Wedding also contained another prediction that went on to become real: in the episode, Lisa and Marge chatted on phones fitted with video screens. After promising Lisa that she'd make sure Homer behaved at the wedding, Marge crossed her fingers, prompting Lisa to remind her that she was on "a picture phone".

13. When thieves made off with some "retirement grease"

In 2008 thieves in New York reportedly began stealing used cooking oil left outside restaurants and selling it as biofuel. They may have been taking inspiration from Homer's "retirement grease": in the 1998 episode Lard of the Dance, Homer discovered he could make a profit through stealing and reselling grease.

14. When the real-life Bart Simpson met the real-life Mr Burns

In 2013, a British man named Bart Simpson, accused of carrying a prohibited firearm, was called to appear before a judge named Mr. Burns at Warwick Crown Court. 56-year-old company director Simpson (full name Barton Simpson) was caught with a .38 Smith and Wesson revolver in his hand luggage at Birmingham Airport. "There were some eyebrows raised when the court list was published," a court worker said at the time. "It's a bizarre coincidence that Bart Simpson is actually on trial in front of Mr Burns, but it'll proceed as any other criminal case would." In the event, the real-life Mr Burns let Simpson off with a fine and community service, acknowledging that the gun had been left in the bag due to a genuine mistake.

15. When the "Good Morning" burger stopped being a joke

Nowadays, given the proliferation of ever-bigger, ever-stranger fast food creations, it's hard to remember that The Simpsons' Good Morning burger – essentially a super-large, super-fatty breakfast burger – was originally intended as a joke. Perhaps the closest real-life equivalent was Burger King's "Enormous Omelet Sandwich". Introduced in 2005 the product consisted of sausage patties, bacon, eggs and cheese within a bun sandwich; it was later criticised for its high fat and calorie content, and discontinued in the US.

16. When a man complained that an "all-you-can-eat" restaurant wasn't living up to its name

In New Kid On The Block, an episode that first aired in 1992, Marge and Homer visited Captain McAlister's All You Can Eat Seafood Restaurant. Homer proceeded to take the "all-you-can-eat" injunction literally, prompting the Captain to declare: "Tis no Man. 'Tis a remorseless eating machine." After being removed from the restaurant before eating his fill, Homer consulted an attorney who advised him to sue. ("This is the most blatant case of fraudulent advertising since my suit against the film The Never-Ending Story.") In 2012, an outraged customer from Thiensville in Wisconsin, Bill Wisth, phoned the police and organised a picket, after an "all-you-can-eat" fish restaurant refused to continue serving him. Closer to home, the same year saw two men banned from a Brighton restaurant, after allegedly regularly abusing its "all-you-can-eat" rule.

17. When the Albuquerque Isotopes became a real baseball team

In the 2001 episode Hungry Hungry Homer, local minor-league baseball team the Springfield Isotopes decided to move to New Mexico and become the Albuquerque Isotopes. Two years later, real-life team the Calgary Cannons announced a move to Albuquerque. When they held a contest for Albuquerque citizens to name the new team, the winning entry was: the Isotopes. Like Springfield, which houses a nuclear power plant (where Homer works), New Mexico is also home to several nuclear research facilities. The term isotope, which refers to a particular form of an element (often a radioactive one) is frequently used in nuclear research.

18. When real-life voting machines began changing people's votes

In a 2008 Halloween special, Homer was seen attempting to vote for Barack Obama; the electronic voting machine continued to register a vote for Mitt Romney instead. This prediction came true during the 2012 Presidential elections, when a Pennsylvania voting machine was recorded doing the exact same thing. A man identified online as "centralpavote" recorded the malfunction on his smartphone and uploaded the video, where it shot to instant fame. The faulty machine in question was subsequently taken out of service.

19. When Simpsons products hit real shops

In 2007, as part of a marketing campaign for The Simpsons Movie, real life versions of a number of well-known Simpsons products appeared in shops belonging to the international chain 7-Eleven (the chain has no UK-based outlets). Cans of Buzz Cola, Krusty-O's cereal, Squishee slush puppies, and a special edition of the Radioactive Man Comic were all sold for a limited period, alongside other The Simpsons merchandise. However, the team behind the marketing stunt decided not to sell the Simpsons' famous Duff Beer, but instead introduced an alcohol-free Duff Energy Drink.

20. When Duff became a real beer, against the programme-makers wishes

Simpsons creator Matt Groening has publicly stated that he will not license the Duff trademark to brew an actual beer, over concern that it would encourage children to drink. That hasn't prevented a number of companies from attempting to cash in by introducing their own version of the product. In the mid-Nineties, the Australian brewery Lion Nathan attempted to sell a beer named Duff, and were subsequently sued by 20th Century Fox. Only a few cans were produced, and have since become collectors items: one case reportedly sold at auction for $US 13,000 (approximately £8000). Germany's Eschweger Klosterbrauerei brewery produces a Duff beer, while England's Daleside brewery produces a dark beer which goes by the name (Duff can be linke dto the Gaelic term dubh, which means "dark" or "black").

21. When hamburger earmuffs became a real thing

Hamburger earmuffs were invented by The Simpsons' Professor Frink, in the 1998 episode The Wizard of Evergreen Terrace. Frink explained to Homer that you can mix any two things together to form an invention; Homer suggested hamburger earmuffs. Frink then revealed that he had already made that particualr invention, and that they'd soon be on the shelves. The professor's words proved prophetic: hamburger earmuffs have subsequently become "a thing". In 2013, the item received an unexpected spurt of fame when Josh Gates, host of the SyFy reality series Destination Truth, ordered a T-shirt on Amazon and received a pair of hamburger earmuffs by mistake. Initially bemused, Gates soon saw the funny side of the mix-up, and began to tweet pictures of himself wearing product, leading to a demand that soon saw the earmuffs sell out.

^{(Picture: Josh Gates via Twitter)}

22. When real-life actors recreated the intro sequence in painstaking detail

In 2010, the UK-based advertising agency Devilfish produced a promotional video for Sky One, in which each frame of The Simpsons famous opening credits was recreated using human actors (and in which Didcot Power Station doubles up for Springfield's nuclear power plant). Matt Groening was so impressed, he later decided to use the clip as the opening sequence in the episode Homer Simpson, This Is Your Wife.

23. When a woman "became" Marge

Earlier this year, makeup artist Veronica Ershova and photographer Alexander Khokhlov worked on a project that transformed real women into works of art: the video below shows how one of their models was turned into an an eerily realistic Marge Simpson. Marge's distinctive towering hairstyle was created via a stack of chrysanthemums, painted blue.

24. When Homer's Land of Chocolate became a real place

In the 1991 episode Burns Verkaufen der Kraftwerk, two visiting German businessmen inform Homer that they are from "the land of chocolate" (meaning Germany). Homer being Homer, he instantly envisages a fantasy land, in which houses, streets, rivers, streetlamps and animals such as rabbits and dogs are all formed from chocolate. In 2013, Homer's dream became a (sort-of) reality, when the Homer-ishly titled theme park Chocolate Happy Land opened in Shanghai. Attractions on offer at the park include a 400 square-metre castle formed from 160 chocolate stands, chocolate handbags, flower vases and jewellary, a chcoolate recreation of China's terracotta army, and, according to this article in Time Out Shanghai, a chocolate Hello Kitty, and "mannequins wearing chocolate underwear and bikinis".

25. When Barbara Bush learnt a lesson from Marge Simpson

Marge Simpson is know for upholding discipline and good manners – and in 1990, the character had to teach First Lady Barbara Bush a few lessons in politeness. Bush said of The Simpsons: “It was the dumbest thing I had ever seen, but it’s a family thing, and I guess it’s clean.” She later received a letter from Marge, who politely rebuked her for describing the show as "dumb". To her credit, Bush then wrote back, apologising for her “loose tongue” and praising Marge for setting a good example to the rest of the country. Her letter even ended with "PS Homer looks like a handsome fella!"