Assets and the market for lemons

I have spent so much time blabbing about asymmetric information without every explaining what I meant. As a result I feel that everyone deserves a little explanation. Thanks goes out to Akerlof and the lemons hypothesis.

Part of the problem in the way I see it stems from the fact that in the marketplace, the potential buyer has less knowledge than the seller of an asset regarding the assets value. In this case, the buyer has to take a punt, guessing what he/she thinks the assets value is, what risks there are around that, and assessing the cost to the buyer associated with taking on that risk. Given this, the buyer will be willing to pay some price for the asset – a price that is less than the price they would pay if they had the same information as the seller.

Now, if the seller of an asset also values the asset based on some fundamental value associated with it. As a result, the value of the asset to the seller may only be a little bit lower than the value of the asset to a fully informed buyer. In this case, the owner of a good quality asset will not want to sell – as the price the buyer will pay is too low. As a result, good quality assets are pulled off the market.

If buyers think this is what is happening (even if it isn’t happening – as long as buyers expect this), they will assume that all the assets available for sale are trash, and will offer a the appropriate price. This in turn leads to the market collapsing – as the buyer doesn’t want the trash assets, but that is all that sellers are willing to sell. Now this occurs even though there are buyers and sellers that could trade beneficially (if the information was symmetric) and as a result, there is a market failure.

Ha, then why didn’t this happen earlier – why the collapse now!

Well, given the existence of asymmetric information the equilibrium we end up in (full trade vs no market at all) depends completely on the structure of “buyers” expectations. As a comment on this post on market movers states:

The financial system has multiple equilibria. In equilibrium A, confidence is high, risk premiums are low, credit is easy, markets are liquid, and collateral is stable or appreciating.

In equilibrium B, confidence collapses, cash is hoarded, credit is tightened, investments are postponed, markets are frozen, and collateral is unmarketable.

It is true that there are “fundamentals” that have to adjust – housing and some asset classes are over-valued. But the re-valuation of these asset classes, and the associated loss of wealth for their owners is a transfer to people on the other side of the market – it is simply something that should be allowed to happen.

The market failure occurs in the case where good quality loans, and good quality assests, get messed up. The way to prevent this is to:

  1. Make information symmetric between agents (impossible),
  2. Inject capital to improve the expectations profile among investors (difficult without messing up the shift to the efficient price of assets – you risk merely delaying the problem of revaluation),
  3. Some third party purchases the toxic assets at “fair value”, leading to a pick up in trading in the market with asymmetric information.

The bailout is the third method. As long as factors surround the “fair value” of an asset, and the potential for moral hazard are taken account of in the setting up of the scheme then this is actually a fair way to solve the asymetric information problem isn’t it?

I realise this is a very different view than I put down here, but I really don’t know what I think (and that was also a critique of them paying too much for assets – which is something that concerns me as well).

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