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Sunday, February 20, 2011

Information Asymmetry and Decision making

Recently, I accompanied my friend who was scouting for a second hand car. Our research in the friends circle revealed that they had burnt their hands getting a deal fixed by a mechanic, they suggested we get to a Maruthi True Value in case we were looking for any Maruthi car.

Looking back at this experience, I could associate it with the problem of Information asymmetry - today business relies very heavily on bridging this information gap. In-fact, this was theoretically identified for the first time by George Akerlof in 1970 and went on to get him the Nobel price in 2001.

Imagine a situation when I have a lot of cars to choose from, and I have little information about the car which I buy from the mechanic. There is every incentive for the mechanic and the owner of the car to conspire and give me a shoddy car!. How do I hedge against this, I decide to give a very low price for the car. Now this act of mine give a blow to the owner of a good car who intends to sell his good car. He too get a low price for the good car. The problem gets extremely challenging since there are so many bad cars and the good cars can't be found easily.

To solve this deadlock and give a better return on the good car, there has to be a way to signal that the car is good - otherwise I have no incentive to pay more. This is where “Maruthi True Value” came in and gave this signal to the potential buyer like my friend that this car is certified by Maruthi itself.

This situation probably has the largest effect on the insurance industry, than others, but this problem is present in almost every business - be it soft drink manufacturer or even at an interview table. The decision making becomes a major issue due to the information asymmetry that we find so prevalent in the environment.

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