Standards and the Information Gap

Between buyers and sellers there is always an information gap. The buyer can not know all that the seller knows about the good he is buying. For example when you buy a car you can’t know if that car was used to transport drugs and is now covered in a light dust of narcotics.  Meanwhile, the seller can never know how much value you might extract from the goods after you purchase them.  How is the seller to know that you have coveted that car since childhood?  This information gap makes price setting difficult and risky. If you highly value the thing your buying the seller would raise the price. If you knew more about the history of the good you might be less willing to pay. This is important: adding information makes it less likely a deal can be struck.

Standards are often used to help reduce the information gap. In some cases standards are set that force one or the other side to reveal information. Cars, for example, have a record kept of significant accidents and buyers can query that data to reduce their uncertainty. Certification and government regulation are two other examples. The public health inspector’s job is to reduce the information gap for restaurants; he does what the dinner would rather not have to. In many of these cases both sides of the transaction would prefer to have the regulation, certification, etc. The rules make transactions flow where they might not have otherwise. Sometimes middlemen play role. Restaurant reviewers are an example of that; assuming they aren’t sock puppets.

Models like this one explain why a car looses so much value the moment it leaves the lot of the new car dealer. At that moment the buyer is forced to assume the worst about the car. This is compounded by the suspicion that private sellers only dispose of cars for negative reasons.

Firms often attempt to create certifications, standards, regulations in the hope reducing the information gap, increasing the number of transactions, and raising prices. A good example of that is the way that all the new car companies have a “certified used car” program of some kind. The idea being that this certification reduces the buyer’s uncertainty about the car and allows the dealer to sell the car for more.

Jay Levitt bought a certified Audi recently. Turns out, to hear him tell it, that Audi’s Certification program is a joke. Maybe they are using one of these online make your own certificate sites.

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