№ XII
The twelve plates
In every bargain one party tends to know more than the other — the seller more than the buyer, the borrower more than the lender, the expert more than the layman — and that simple inequality is enough to bend a market, and sometimes to break it. This volume is about asymmetry: the market for lemons and the signal that answers it, the screen and the hazard and the incentive, the seal and the mandate, and the contest, beneath every price struck in unequal knowledge, over who knows, who hides, and who pays.
when buyer and seller know different things, the market's outcome wears the look of the natural price of quality and risk — but is it more than the frozen advantage of whoever knows the more?
In every exchange there is a chance that one party knows more than the other. The seller of a used car knows whether it is sound; the buyer does not. The applicant for insurance knows his own health and habits better than the company that must price his risk. The borrower knows what he means to do with the loan; the lender can only guess. The worker knows his own diligence, the physician his own care, the expert in every field more than the layman who must hire him. This inequality of knowledge — that the two sides of a bargain do not see the same things — is so ordinary that we scarcely remark it; and yet it is enough, on its own, to bend the outcome of a market, to distort its prices, and at the limit to unravel the trade altogether. This volume is about that inequality, which the economists call asymmetric information, and about the surprising amount of economic life that turns out to be organized, one way or another, around the fact that we do not all know the same things.
The founding insight is the youngest in this work, and among the most consequential economics has produced. In 1970 George Akerlof asked what becomes of a market in which sellers know the quality of what they sell and buyers do not — the market, in his example, for used cars, where a seller knows whether his is sound or a lemon. A buyer who cannot tell them apart will pay only what the average is worth; but at that price the owners of the best cars withdraw, unwilling to sell a good car for an average price, so that the average quality falls, and the price with it, and the next-best cars withdraw in turn. The market threatens to unravel toward the worst — the bad driving out the good — not through fraud or scarcity but through the mere fact that quality is hidden. Akerlof named the mechanism adverse selection, and his demonstration that a market could fail from asymmetry alone, with no monopolist and no spillover in sight, opened a new continent of economics and, three decades on, won a Nobel Prize.
If a market can be wrecked because quality is hidden, it can be saved by making quality visible — and much of the machinery of real markets exists to do exactly that. The informed party can signal, in Michael Spence's term: take some action that only the genuine article would find worthwhile, a thing too costly for the false type to imitate, and so reveal by deed what words cannot establish — the unconditional warranty only a sound product can afford, the education that vouches for a worker's quality, the brand built at an expense only a firm expecting to last would bear. The uninformed party, for its part, can screen, in the manner Joseph Stiglitz analyzed: offer a menu of terms designed so that the different types sort themselves, as the insurer's choice between full coverage at a high price and a large deductible at a low one leads the reckless and the careful to declare themselves by their choosing. Signaling and screening, certification and reputation: the market does not suffer its asymmetry passively but grows elaborate institutions to fight it.
Hidden quality is only half the trouble; there is also hidden action. A man insured against fire takes less care with his candles; a manager spending shareholders' money may chase empire rather than profit; a borrower may gamble with funds he would never risk were they his own. Wherever one party bears the consequences of another's unobserved choices, the incentive to take care is quietly corroded — a condition the insurers named moral hazard, and which reappears in every relation where someone must act on another's behalf without being fully watched. Adverse selection concerns what the other party is; moral hazard, what the other party does; and together they map the two ways unequal information can distort a dealing. Both, moreover, share a deeper feature, which is the true subject of this volume.
For the outcome of a market shaped by asymmetry wears, like every outcome in this work, a false face of necessity. A price is a verdict on a hidden contest, mistaken for a fact of nature — and the prices struck in unequal knowledge are verdicts of just this kind. The high cost of the insurance, the low price of the used car, the wage premium a credential commands, the rate of interest a borrower of unknown risk must pay: each looks like the natural price of a quality or a risk, set by the impersonal meeting of supply and demand. But each is in truth the product of a particular distribution of knowledge — of who knows what, of what can be concealed and what revealed — and of the institutions that happen to exist for bridging the gap. Change the information, or the signals and screens and certifications that govern it, and the price changes; it was never the dictate of nature it appeared to be, but the residue of an arrangement that could have been otherwise.
And beneath that arrangement, as always, lies a contest. A price is a verdict on a hidden contest, mistaken for a fact of nature; in the markets of this volume the contest is over information itself — its concealment and its disclosure, its possession and its proof. The better-informed party strives to turn its advantage to profit: the seller to hide the defect, the borrower to mask the risk, the expert to find more need than there is. The worse-informed strives to protect itself: to extract the signal, to design the screen, to compel the disclosure. The market's outcome — who captures the gain of the hidden knowledge, who bears the loss of the hidden risk — is the frozen result of that struggle, not a fact of the world. Information, in these markets, is not a given but a stake: fought over, withheld, signaled, certified, mandated, and never simply there. To read the resulting price as the natural price of quality is to mistake the spoils of an informational contest for the order of nature.
With this volume the family of failures is complete. Economics has long recognized a handful of ways in which the market's central promise — that voluntary exchange leaves all parties better off — can break down: the monopolist who throttles supply, anatomized in the volume on power; the polluter whose costs fall on others, the subject of the volume on externality; the unowned resource that all may use and none will tend, the matter of the volume on the commons; and now the asymmetry of information, the fourth of the classic failures, in which the market falters not from too much power, nor from uncosted harm, nor from absent ownership, but from unequal knowledge. The four are the canonical breakdowns of the market, and they share a single moral, which is the moral of this entire work: that each apparent law of the market — its prices, its allocations, and its failures most of all — is on inspection not a fact of nature but a contingent product of institutions; and the volume on skill has already shown one of these informational forces, the signal, at work within the wage itself.
The twelve plates follow the asymmetry through its forms and its remedies. They set out the lemon and the signal that answers it, the screen by which the uninformed sort the types and the hazard of the action that cannot be watched; the incentive contract that strains to align an agent with his principal and the warranty that binds a seller to his word; the seal by which a third party vouches and the pool in which insurance gathers and unravels; the mandate by which the law compels disclosure and the credence good whose quality the buyer can never check; the herd that forms when each reads the crowd for the knowledge he lacks; and, at the last, the curtain — whether the gap between the knowing and the unknowing can ever be drawn back, or whether some asymmetry is the irreducible condition of a world in which knowledge is unequally shared, so that the verdict of an unequal market can never be read as a simple fact. The market does not abolish its asymmetry; it manages it, and the managing is much of what markets do. The argument remains open.