Mental Model: Information Asymmetry
For the past month or two, there has been a running joke at the office that I’ve been giving Aaron a hard time about, providing me countless hours of entertainment. It is a good illustration of a mental model from economics called information asymmetry and I thought I’d take five minutes over a fresh cup of coffee I poured moments ago to explain this concept to those of you who use the same rational framework for life and business.
[mainbodyad]Information asymmetry is where one party in a transaction or event has better information than the other. This creates an “imbalance of power” that can result in someone thinking they are acting rationally when they are not in the larger context; they are only acting rationally with the knowledge they possess, which is incomplete.
Information asymmetry is often relegated to economics but it is much bigger than that. It can help or hurt your pocketbook, career, relationships, and reputation. For example, many techniques used in “dirty politics” rely on information asymmetry in the voting population. People fear information asymmetry so much that they will often accuse someone of a transgression called “lying by omission” if they find themselves a victim of it because you withheld information that they feel as if they had a right to know.
A Humorous Case of Information Asymmetry from My Own Life
In mid-May, Aaron and I flew to the East Coast to attend a scholarship benefit concert honoring a woman we admire tremendously. We had been asked to speak at the event.
For me, public speaking has never been a problem. In some ways, I have the heart of a college professor. There are no nerves or anxiety. It’s just not a big deal. For Aaron, though, it is an unpleasant experience. A room full of people staring at him waiting for him to orate is not his idea of a good time.
Prior to flying out of Kansas City, he made me a deal and required me to promise that I would give the entire speech as he stood at my side and, in his words, “nodded, maybe even interjecting once or twice if I feel like it”. Of course, I got sick for the first time in years and spent several days of the trip nearly knocked out in a hotel room with the shades drawn. I wasn’t even sure I’d be able to attend let alone speak, but I’m thankful that I recovered in time.
The night of the concert, as we were sitting on the front row about to give our portion of the event, I still didn’t feel that great. I leaned over and whispered in Aaron’s ear, “If I go down, lose my voice, or just can’t go on, you’re taking over, right?”
Aaron looked at me and said very seriously, “Nope. I’ll smile at the crowd, say, ‘I guess that’s all folks’, and drag you back to the seat.” He wasn’t kidding. Knowing that it was important to him, I acquiesced.
Fast forward a few weeks. One of the people we were friends with back in our college days said, “Joshua. A bunch of us were talking about how you didn’t even let Aaron speak at the concert! You monopolized the entire conversation. You are way too controlling!”
Not All Cases of Information Asymmetry Are Benign
That is information asymmetry. The good news is, in our case, it was completely benign with no one hurt. Here, we had two private individuals making a deal – Aaron needed me to do something, which I did with purely altruistic motives – yet those without complete knowledge of the situation had a different perception of what happened that appeared, in this case, to be the polar opposite of reality. That missing variable (the motivation of our actions) was in our possession but not theirs so you had information asymmetry. There was also a missing understanding of Aaron’s nature (no one controls him – he’s as strong-willed and focused as I am; in some areas of life, even more so).
This has turned into a fantastic running joke for me. For a good month, I’ve given him a terrible time about it. Aaron might ask me to pick up lunch on my way back from a meeting or appointment and my response is, “I would, but what if they are out of something and I have to make a selection for you? I really don’t want to be that controlling so I’m going to let you fly free to go get your own lunch.”
Not all instances of information asymmetry are so entertaining for the people involved. Information asymmetry can cause financial or emotional disaster. In extreme cases, it can lead to bankruptcy, broken hearts, embarrassment, shame, and even death. Victims of it, whether guilty or not by their own ignorance, will rage about being “made a fool”. The most dangerous cases of information asymmetry are often based upon wounded pride.
Information Asymmetry In Business
In business or politics, asymmetry can put a person on the less knowledgable side of a transaction at a huge disadvantage. If two investors are bidding on a peanut farm and one knows that the farm in question is sitting on natural gas reserves, he can pay a higher price for the farm and still expect to earn a good return.
The power of information asymmetry is so potent that we have created laws against insider trading. Following the Great Depression, you can only buy or sell securities in the stock market based upon publicly available information. Since most people don’t read everything they can and don’t have the time to invest in studying and understanding it, information asymmetry can still be present. That is one of the reasons you might be able to buy part of a company in the form of a piece of stock through the stock exchange for less than the private market value, but you aren’t likely to find those kinds of bargains if you bought the entire firm. In the latter situation, dozens of trained lawyers, accountants, and advisers are likely to look over the company and provide input, reducing the odds of information asymmetry.
Tricks To Avoid Information Asymmetry
There are a few things you can do to lessen your chances of being on the wrong side of information asymmetry.
- Avoid Assumptions: This is so vital that I wrote one of the site’s most popular articles about the importance of checking your implicit assumptions. Assumptions are an enormous vulnerability that can be exploited against you or make you look foolish; a lesson the kids in my family learned early because my grandfather was fond of saying, “when you assume, you make an ass out of u and me.”
- Stick to What You Know. A “Circle of Competence” Is Really Just a Way to Guard Against Information Asymmetry: When Warren Buffett talks about the “circle of competence”, a concept he borrowed from the legendary IBM leader Tom Watson, it’s really a defense tool against information asymmetry. By only sticking to areas you understand and looking for opportunities within them, you put yourself at an advantage rather than a disadvantage. Someone who invests the time, energy, and money to understand the oil industry is going to have not only better information, but in all likelihood, a better analysis of that information than someone who is trying to casually buy into an oil company but doesn’t know much about hydrocarbons.
There is an entire body of economic research on information asymmetry, including ways people and institutions cope with it. Another technique is screening, by which the disadvantaged party can get the advantaged party to reveal what they know through the framing of questions. Yet another is signaling, which explains why an MBA might be important to becoming a CEO even though numerous high-quality studies have shown there is zero correlation between being a successful executive and receiving a business degree. The advanced degree “signals” to a hiring agent that the person is disciplined and can learn.
Information asymmetry can also be an advantage to those who act morally and ethically. If someone has a reputation for treating folks fairly and honorably, people are more likely to do business with him as a result, increasing long-term returns compared to the short-term profits earned by a conman. This is especially true in industries with high information asymmetry, such as used cars.