The balancing of market Information

In my previous columns on disintermediation, there is a rather large assumption I have made – being that the market will continue to see a balancing of information available both to buyers and sellers. As this information becomes more available, the need for the “middle” will decrease.

Information asymmetry defined

Let’s begin by exploring the concept of information asymmetry, courtesy of George Akerlof, Michael Spence and Joseph Stiglitz.

In markets where access to information is unbalanced, bad things can happen.

If the buyer has more information than the seller, then we can have something called adverse selection. Take life and health insurance, for example. Smokers (on the average) get sick more often and die younger than non-smokers. If an insurance company has 50% of their policyholders who are smokers, and 50% who aren’t, but they’re not allowed to know which is which, they have a problem with adverse selection.  They’ll lose money on the smokers so they’ll raise rates across the board. The problem is that non-smokers, who don’t use insurance as much, will get angry and may cancel their policy. This will mean the “book of business” will become even less profitable, driving rates even higher.    The solution, which we all know, is simple – ask policy applicants if they smoke. Imperfect information is balanced out.

If the seller has more information than the buyer, then we have a “market for lemons” (the name of Akerlof’s paper). Here, the buyer is assuming risk in a purchase without knowingly accepting that risk because they’re unaware of the problems that the seller knows exists. Think about buying a used car, without the benefit of an inspection, past maintenance records or any type of independent certification. All you know is what you can see by looking at the car on the lot. The seller, on the other hand, knows exactly the mechanical condition of the car. The impact of this is that it tends to drive down the prices of all products, even the good ones, in the market because buyers assume quality will be suspect. Balancing of information in this case helps eliminates the lemons and has the long term effect in improving the average quality of all products on the market.

Getting to know you…

These two forces, the need for sellers to know more about their buyers, and the need for buyers to know more about what they’re buying, is driving a tremendous amount of information gathering and dissemination. On the seller’s side, behavioral tracking and customer screening are giving companies an intimate glimpse into our personal lives. On the buyer’s side, access to consumer reviews, third party evaluations and buyer forums are helping us steer clear of lemons. Both are being facilitated through technology.

But how does disintermediation impact information asymmetry, or vice versa?

If we didn’t have adequate information, we needed some other safeguard against being taken advantage of. So, failing a rational answer to this particular market dilemma, we found an irrational one – we relied on gut instinct.

Relying on relationships

If we were to place our trust in someone, it better be someone we could look in the eye while we were dealing with them. The middle was composed of individuals who acted as the face of the market. Because they lived in the same communities as their customers, went to the same churches, and had kids that went to the same schools, they had to respect their markets. If they didn’t, they’d be run out of town. Often, their loyalties were also in the middle, balanced somewhere between their suppliers and their customers.

In the absence of perfect information, we relied on relationships. Now, as information improves, we still want relationships, because that’s what we’ve come to expect. We want the best of both worlds.

Orig­i­nally pub­lished in Mediapost’s Search Insider October 25, 2012