What are information gaps in economics? Are seller-buyer information gaps good for the economy?<\/p>\n\n\n\n
When one party doing a business deal has more information than the other party, there is an information gap. Usually, the information gap is such that the seller has more information than the buyer. When this is the case, the market is not running efficiently.<\/p>\n\n\n\n
This article explains the information gap, discusses how to close it, and examines how to solve broken health care systems using these economic principles. <\/p>\n\n\n\n\n\n\n\n
We\u2019ll use the example of used cars to explain the concept of information gaps in economics. Let\u2019s say half the cars on the used car lot are \u201cpeaches\u201d\u2014they run well\u2014and the other half are \u201clemons\u201d\u2014there\u2019s something wrong with them. The car salesman knows which are which, and the buyer does not. The peaches are worth an average of $6,000 to buyers. The buyer offers $3,000, which she thinks is a fair gamble for a car that could be a peach or could be a lemon. <\/p>\n\n\n\n
Consequently, buyers offering $3,000 will only ever get lemons. If the buyer offers closer to $6,000 the salesman might give up a peach, but the buyer wouldn\u2019t be willing to put up something like $5,500 for a 50% chance she\u2019s getting a lemon. <\/p>\n\n\n\n
In this extreme example, there is literally no market. Buyers who have even an ounce of common sense<\/a> just won\u2019t shop for a used car. Consequently, sellers won\u2019t sell many used cars. Insider information helps no one. This only occurs when one group is ignorant and the other has knowledge. If both the buyer and the seller are ignorant, the market would resolve itself. The problem is the knowledge gap. <\/em><\/p>\n\n\n\n (Shortform note: Read our summary of Freakonomics<\/a> to learn how unequal access to information affects you when you\u2019re buying a house, and how the Internet is closing the information gap.)<\/p>\n\n\n\n So, how can we solve the knowledge gap? The first way<\/a> is for vendors to <\/strong>signal quality<\/em><\/strong>, or to show customers that they are reliable. <\/strong>There are lots of ways for vendors to do this. In the car salesman example, trustworthy salespeople often have a showroom that\u2019s a lot fancier than a used car lot on the side of a highway. These showrooms are fairly expensive and require long leases. If a salesperson has roots in the community thanks to their lease, they can\u2019t just pick up and leave if they start selling lemons and word gets around that they are not to be trusted. If they can\u2019t quickly leave and move on to a new group of suckers, they\u2019re disincentivized to withhold important information from customers. Thus, customers trust salespeople with showrooms because the quality of the showroom signals that the seller can\u2019t rip the buyer off. <\/p>\n\n\n\n This is also why old banks often found fancy buildings to conduct their business out of. If you\u2019re giving your money over to an organization to hold, you want to make sure that it\u2019s trustworthy. Signposts of trust like a stately building aren\u2019t just nice frills: The expensive lease in the fancy building makes sure that vendors will be honest with customers.<\/p>\n\n\n\n There are many signals of quality that don\u2019t involve real estate as well. For example, people like to poke fun at students getting their degree in a subject like philosophy. The popular argument is that philosophy doesn\u2019t give students any marketable skills that will help them make money. But finishing a philosophy degree is another signal of quality. Philosophical arguments are dense. While reading and writing about them might not be directly related to whatever job a philosophy student has after graduation, it shows a level of commitment that employers pick up on. If someone is excited to study philosophy, they likely have a good work ethic<\/a>. <\/p>\n\n\n\n Remember, though, that all of these examples are trade-offs. It might not be worth the money to pursue a philosophy degree, even if it does make it marginally easier to secure a job because you can better signal quality. <\/p>\n\n\n\n While vendors can <\/strong>signal quality <\/em><\/strong>if they choose, it is often up to customers to <\/strong>find quality. <\/em><\/strong><\/p>\n\n\n\n Let\u2019s use renting an apartment as an example. When landlords show off an apartment to potential tenants, they are signaling quality <\/em>by allowing customers to test that everything works in the apartment or look around the place and the neighborhood. But potential tenants and landlords can both find quality <\/em>in one another to close the information gap. <\/strong>There are all kinds of forums where tenants can share positive or negative experiences about landlords: Potential tenants can seek out this information online, or ask other tenants in the building directly about whether the landlord is responsive. Landlords, though, need information about tenants as well before they agree to rent out their place. They don\u2019t want tenants who can\u2019t pay their rent. So they find quality<\/em>: <\/em>They regularly ask for bank statements, proof of employment, and tax returns. When each party has enough information about the other, they can comfortably complete the transaction. <\/p>\n\n\n\n The knowledge gap is a big problem in the health insurance industry, especially in nations with broadly private health insurance systems like the United States. Let\u2019s say that people who are prone to sickness are lemons and people prone to good health are peaches. If peaches\u2014young people without health problems\u2014don\u2019t buy insurance, the market starts to disappear. Without their money paying into the system, insurance gets more expensive for those between a lemon and a peach, and their plans become too expensive to be worth the expenditure. <\/p>\n\n\n\nSignaling Quality<\/strong><\/h3>\n\n\n\n
Finding Quality<\/strong><\/h3>\n\n\n\n
Insurance<\/strong><\/h3>\n\n\n\n