45. DVD set of Minder – information asymmetries
The average reader of Investors Chronicle is old enough to remember just how special Monday evenings were in the early 1980s. By 9pm it was vital that they were settled in front of the little box in order to watch one of the best comedy dramas that British television has ever offered. From Thames Television and the genius of Verity Lambert came Minder.
Hence this week’s object – a DVD set of the complete series starring George Cole as Arthur Daley – 109 episodes etched on to 33 discs available for £42.72 from Amazon. Or – and here’s a great bargain, guv’ner – to you, £36 for a used version; barely used, mind you.
Arthur Daley was one of TV drama’s great characters, not least for giving the world such phrases as “nice little earner”, “her indoors” and “the world’s your lobster”. Unknowingly, he was also the walking embodiment of one of the great insights of modern economics, which has applications in every sort of market.
While he had fingers in many pies, Arthur was primarily a used-car salesman. But that prompts the question: would you buy a used car from this man? The instinctive answer would be, “you’re kidding”. But it took a paper written by a young American economist, George Akerlof, who had just completed his PhD, to explain why.
Mr Akerlof’s paper, The Market for Lemons, was serially rejected by economics journals both because of its triviality and what appeared to be its basic error. In effect, it explained how a used car offered by Arthur Daley would fail to sell because of what economists called ‘information asymmetries’. Put another way, Arthur knew that the Ford Granada he was selling was a lemon, but he passed it off as a stunning motor. Simultaneously, the punter wasn’t as dumb as Arthur thought. Sure, the car looked nice enough, but he couldn’t tell the state of the tappets or whether the big end was about to go. So, because Arthur was selling it, he assumed it was a dud.
So far, so fair. But just occasionally Arthur really did have a genuine motor to sell. The trouble was, no one believed him. So, in order to shift the good car, he had to cut its price to the level of the dodgy motor. As a result, Arthur got fewer and fewer good cars to sell. Buyers assumed that the only cars he offered were rubbish and went elsewhere. Arthur’s used-car business began to fail.
Writ large, this is how markets also fail. Sellers know what they are selling but are not completely transparent about it. Buyers don’t know about the state of the goods on offer, but at least know that they don’t know. Therefore they assume the worst. As a result, the good assets get underpriced and are driven out of the market or, worse, prices collapse and the market fails.
The principal objection to Mr Akerlof’s paper was that it was contradicted by the facts. Clearly there was a market for used cars in the US that, for the most part, functioned well. True, but ‘for the most part’ does not mean always and most of the time markets are not as liquid or as keenly priced as they might be because of information asymmetries.
Take the market for insurance where the asymmetries are switched and buyers of policies know more about what’s insured than the sellers (the underwriters). That means in all markets where insurance is optional, insurers must overprice policies since they assume that their customers will be only those who really need to buy or don’t care about the price. It also means that the good risks – the people who think it would be prudent to buy a policy but only at an acceptable price – are priced out of the market. As a result, the pool of insurance policies is smaller than it could be and insurers get less benefit from the diversification that size would bring. The market falters.
Information asymmetries also affect companies and their investors. There is the ‘principal-agent problem’ where the principals (the shareholders) hire agents (the managers) to run the company for their benefit. The problem is that soon enough the agents know much more about the company than the principals – and they use that knowledge to their own advantage, especially by hoarding cash to give themselves an easy life. Solution: demand that the managers distribute more profits as dividends. That way, the dividends both signal the financial strength of the company and they remove the comfort blanket of cash that cossets the managers.
At the extremes, however, markets do fail. Take the collapse of bank-to-bank lending – the wholesale money market – which dried up following the collapse of Lehman Brothers in 2008. Lenders suddenly realised that they knew almost nothing about the collateral for the loans they had made, the so-called collateralised debt obligations (CDOs) that had been churned out by Wall Street’s money machine. Instantly, all CDOs were lemons; not so much an information asymmetry as an information black hole – no one knew anything so feared everything.
Pity that more bankers had not read Mr Akerlof’s paper, which was finally published in 1970, three years after it was written. And they had no excuses. By the time Lemon Brothers – sorry, Lehman Brothers – collapsed, Mr Akerlof had jointly won the 2001 Nobel Prize for economics for his work on information asymmetry.
