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Richard Thaler and Sendhil Mullainathan on Information Asymmetry

In standard models with asymmetric information, the parties involved are assumed to have private information about their own characteristics. That means, I should know more about me than you know about me. This plays out in many different ways.

“In the health insurance market, for example, customers are typically assumed to know more about their health status than insurers do, and if the customers use this information in deciding whether to buy insurance, we have a classic case of adverse selection.”

Technology, however, has changed all of this. For example, because search providers (e.g., Google, Bing) keep and analyze detailed search information, they can know more about you than you do. “Similarly, a credit card company may know more about a customer’s probability of incurring a late fee than the customer herself.”

In this interesting paper, Richard Thaler, Sendhil Mullainathan, and Emir Kamenica explore the consequences of this reversal in the information asymmetry.

When firms possess better information than consumers do, however, three major issues arise.

First, such asymmetry can give scope for novel regulation. Firms that are collecting data about their consumers’ usage could be required to share those data with their customers. Richard H. Thaler and Cass R. Sunstein (2008) introduced the idea of a new form of disclosure they dubbed RECAP. The basic idea is that firms would provide two types of machine readable files in a uniform format: (i) they would publicly disclose their pricing scheme, indicating how a customer’s usage determines her final bill, and (ii) to each customer, they would provide information about her personal usage data. Consumers could then upload their usage files to third-party web sites that would use the now easily available information on pricing schemes to help the customers compare and evaluate plans from service providers. In the United States, policy makers are already considering adopting RECAP-type disclosure rules in domains such as calling plans and credit cards.

Second, there are important new legal questions raised by such an asymmetry. We suggest that, as a matter of first principles, consumers should have the right to their own purchasing history, as long as providing that history is not very costly to the firm.

Third, when the seller has more information about expected usage than the customer, they may try to exploit this information by targeting specific offers to specific consumers. A credit card company that knows you are absent-minded and occasionally miss your payment deadlines can offer you a “free” credit card knowing that they will make their profits off of your late fees. We call this type of opportunity for firms adverse targeting: firms offer prices that are less advantageous than consumers’ naive expectations about their usage would lead them to believe.

They conclude:

Modern information processing technologies are allowing sellers to know increasingly more about their consumers purchasing behavior. In many cases, this knowledge allows the seller to improve the services it provides, such as providing suggestions of the form: if you liked this book or movie you might also like X. However, this knowledge can also create an information asymmetry in which the seller knows more about a consumer’s habits than the consumer does. In some cases the seller will be able to use this informational advantage to construct special offers that the consumers will over-value. We call this adverse targeting.

Modern technology can also be used to provide consumers with the ability to become better shoppers. We have discussed the possible advantages of requiring firms to provide machine-readable data on pricing and usage. Such regulation, RECAP, might be able to undo the aforementioned information asymmetry. Consumers would know themselves at least as well as their service provider. RECAP could also help unveil the prices of some attributes that sellers may otherwise choose to shroud.

Additionally, RECAP can offer regulators an alternative method of monitoring and discouraging abusive pricing tactics. Rather than engaging in a continuing game in which some pricing strategy is banned only to be replaced by another one, regulators would use data availability and transparency to help markets become self-policing. This would happen not because firms would suddenly become socially conscious, but rather because the third-party web sites would shine a bright light on sharp practices.

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Source: Helping consumers know themselves