Economics of asymmetric information

Asymmetric information refers to a situation whereby one party to a transaction has some information about the transaction relevant to optimal decision making which the other party(ies) do not have.

For example, assume there are only 2 kinds of people in this world - sick or healthy. They are all interested in buying insurance. Obviously it seems intuitive that the insurance company should charge a higher premium for sick people since they are more likely to die and to charge a lower premium for healthy people who are less likely to die. However, that is only possible if the insurance company KNOWS who is sick or who is healthy. In reality, the insurance company won't know the Dick who walked into their company doors one day to buy insurance is a rock climbing enthusiast who runs marathons, or a good-for-nothing bummer who eats bacon and eggs all day, chain smokes and drinks alcohol like plain water.

So what happens? The insurance company, in order to remain profitable, is forced to charge according to the assumption that you are a sick person, or at least that you have half a chance to be a sick person. This then raises the premium for a healthy person from the optimal situation. And being the rational consumer that he healthy person is, he will choose not to buy insurance. The insurance company is then left with sick people as customers, and of course they are not going to sell insurance to sick people. And thus the end result is everyone is worse off with no insurance.

Yeah so what?

In life, situations of asymmetric information arise all the time. When you buy stuff from ebay, you are not certain whether the thing you buy is as good as described by the seller. When you are walking on a street with a shady looking character walking towards you, you do not know whether he is a normal person or has evil intentions. When a salesman is trying to sell you something, you do not know whether to trust all his words.

Uh-huh, SO WHAT??

Most importantly, in everyday interactions with people, you do not know what the other person is thinking about. You always have to second guess the real/hidden meaning of the other person's words. Take for example:

Guy: Hey, it's late, I think it's better if I walk you home. If not very dangerous.

Girl: Hmm, no need lah. Quite safe one. Very short distance only also.

*Pause*

What should the guy do? It all depends on his assumptions about what is the real meaning of her words?

1. Did she really mean that it is safe for her to walk home?
2. Did she just want to be polite and not want to trouble the guy?
3. Or was she just politely telling him that she has had enough of him and asking him to fuck off?

In the first 2 cases, the guy should then insist on walking the girl home. The girl will be 99.9% safe and goes home with good impression of guy. Guy does a good deed and feels gentlemanly. Optimal situation.

And of course in the 3rd case, the guy should quickly just fuck off from her sight. Optimal situation.

But in the world of assymetric information, assumptions may be wrong. For example, if the girl means number 2, but the guy thinks its number 3, optimal situation would not occur. Guy goes home feeling sad. Girl goes home thinking the guy is ungentlemanly. If the girl means number 3 but the guy thinks its number 2, the guy insists on going home with the girl. Girl thinks the guy is irritating, guy probably won't get another chance with the girl next time.

Of course, if the relationship between the 2 individuals (generalising to between anybody now...not just boy-girl) had reached a certain level, the chances of making the right assumptions do increase. But that doesn't mean that he/she will get it right all the time. On a more fundamental level, how do you know what the other person is thinking? The person may say "it's all right", "I don't mind", "Sui bian", "Cin cai" but do they really mean what they are saying?

Are they really indifferent between the options available?

How many times have you made the decision then after a while realised actually they were not that indifferent after all?

How many times have you made a decision only to realise that it was not the optimal because you had the wrong impression (i.e wrong assumption in our model)?

In case you all haven't noticed, I have always been thinking about this. The recent work load, bad luck or just plain irritating incidents just seem to bring the kao peh side of me out. I hate not knowing what other people are REALLY thinking. I know the world would be very boring if everything is as clear as black and white, but I am really getting xian of wasting other people's time/getting people irritated/making myself miserable/generally just making the wrong choice or comment. It would be helpful if everyone had a traffic light somewhere telling me what to do. I may be colour blind but at least I know the light at the top is no-go, the one in the middle means "hey, watch it, it's coming close now" and the light at the bottom is "full steam ahead!".

I am dumb, socially inapt. So next time please at least give me some indication as to what you really think. On second thoughts, make that a big broad hint. It might just lead to a much much better outcome.

Rambling over. Need to prepare for presentation discussion tomorrow. Sigh I hate work, but I won't drop it because it's interesting. Back to workload vs interest again. Bummer