The magic of supply and demand is that buyers and sellers are both made better off by trading with each other, and market forces ensure that all beneficial trades happen. But a key ingredient in our supply-and-demand framework is good information. Without it, things start to fall apart.
When someone knows things that others don’t, the forces of supply and demand are disrupted. If buyers can’t tell who is selling high-quality goods, sellers of high-quality goods have less of an incentive to sell them, and buyers may have less interest in the lower-quality goods that end up being available. The result is lower prices and fewer sales. When you can’t tell how much each customer will cost you, you will end up with more high-cost customers, driving up your costs. This then causes you to raise your prices, which drives away lower-cost customers. The result is higher prices and fewer sales. And when you want to hire someone, but can’t tell how hard they are going to work, you can expect them to do less of what you want. This reduces your willingness to hire people to do things on your behalf. The result is less hiring.
In each of these cases, private information leads to lower quantities bought and sold. Opportunities for mutually beneficial trade or cooperation are lost. In the worst cases, markets can collapse completely. Most of the time though markets don’t quite collapse. Instead, they operate less efficiently than if all people were similarly informed.
People holding an informational advantage are not necessarily trying to take advantage of others. Instead, they’re simply responding to incentives. Imagine if you woke up this morning and found out that your auto insurance had expired. Would you drive more carefully? And if you started spending more time in a high-crime neighborhood would you tell your auto insurer about the increased risk of car theft? If you’re selling your car will you ’fess up about all of its problems?
Markets would yield better outcomes if everyone always told the truth and trusted each other. Since information problems pervade so many of our interactions, societies with higher levels of trust have better-functioning economies. This is also part of why people rely so much on personal networks for everything from jobs to housing to shopping. Inside our personal networks, we face greater pressure to be honest about what we know and to be true to our promises—pressures that reduce the problems of private information.
Beyond trust, improving information or better aligning incentives can help markets function more smoothly—allowing more people to buy and sell what they want. When there is private information, both the private sector and the government can help markets function better by encouraging truth-telling, providing information directly, or creating incentives for the right mix of participants in the market.
To be a savvy shopper in a world full of private information, you need to be on the lookout for what you don’t know, understand how it shapes incentives faced by sellers, and take action to fill in your information gaps. And when you’re the one with private information, you can make better deals if you find credible ways to signal your qualities or otherwise credibly reveal your private information. For instance, if you want to pay less for auto insurance, let your insurance company monitor your driving. And if you want to give it your all at work, help your manager find ways to observe your efforts.
We began this chapter with big differences in information. I knew about moral hazard and adverse selection, and you didn’t. We’ve solved that information problem, and now you have the tools to tackle other information problems you encounter.