Musings about Asymmetry

Hat tip to Freakonomics, who gives us an article worth reading today. If you're feeling lazy, I'll summarize:

1) Sam needed an apartment in Queens.
2) He came across one and it seemed like a good deal.
3) He signed the lease.
4) He soon discovered why it was a good deal—the basement flooded every time it rained.
5) He lost out: none of his storage space was useful.
6) Worse still, he lost everything he stored down there.

The author describes the situation as textbook information asymmetry. I don't disagree. And information asymmetries can be really really pernicious. One simple example:

Insurance companies end up charging higher rates because they can't know how much you conceal. (Think life insurance and closet smokers, for example.) Insurers detest liars, because the threat they pose is expensive—beyond expensive, really. It's limitless liability for unexpected bills at unforeseeable amounts. So, insurers feel a pinch and they find a way to cope. They pass it along to you. But that's incredibly inefficient; it means most of us create producer surplus whenever we're insured (at least, the non-liars among us). We're never taken for the risks we pose, so we're never considered the assets we are. We never get to probe the insurance company's reserve price for us, because they never buy us. So we're never haggling to an equilibrium: non-liars see a shortage and liars see a glut, and there's never resolution! There's a neverending surplus at both ends!**

But it's not like these surpluses negate each other—maybe on the insurer's balance sheet, but not for overall society. Each time we buy a policy, we're paying for something that we shouldn't. We're paying for a risk that doesn't apply to us, and that we know doesn't apply to us. But, because of the nature of insurance, we're forced to buy it anyway. That means every insurance policy ever written cost each party to the transaction the value of trading freely, which in turn causes every insurance market to fail. There are non-liars uninsured who shouldn't be. There are liars not internalising their price. And there are many deals struck between parties less-than-optimally.

**To clarify: the shortage and glut in supply owes to the unitary nature of the insurance policy. There is no liar-specific insurance policy (or non-liars' insurance policy, for that matter). So, the supply of available policies responds to an aggregate demand: both liars and non-liars are bartering for the same good. That means the price pressure is an aggregate too. Liars push prices up because they'd buy at unfathomable costs—but they don't have to. Hence, a glut. Similarly, non-liars push prices down; the ones that buy compete with price-insensitive liars for a perceived necessity—and some drop out altogether. Hence, a shortage.