Chapter 2: Information Asymmetry

“What do the Ku Klux Klan have in common with a group of real estate agents?”
Answer: They both use fear to leverage their informational advantage.

As a terrorist organization, the Klan’s principle tool was fear. Fear translated to power, and once Reconstruction ended the oppression of American blacks ensued. It wasn’t until the late 1940s, after the Klan was infiltrated and its secrets exposed, that it lost this weapon, and membership declined.

Similarly, real estate agents use fear to motivate home sellers and buyers into using their services. The fear is that without a real estate agent, a buyer or seller won’t be able to get a good price.

Yet real estate agents don’t always work in their principal’s interests. Take for example a couple who wants to sell their house for $300,000.

For a $300,000 house, a 6 percent commission – split four ways between the buyer’s agent, the seller’s agent, and their respective agencies – would result in $4,500 going to the seller’s agent. If, however, the house were worth more than $300,000, what incentive would that agent have to work harder?

Working extra hard to get an additional $20,000 for the seller would only net the agent another $300. Compared to the money gained by sticking to the initial asking price, that’s really small – it’s often not worth the trouble.

In fact, there’s a greater incentive for the agent to sneak information to the buyer in exchange for a guaranteed sale. Rather than risk all of $4,500 on a house that may or may not sell at that price, they might be willing to sacrifice $300 in order to secure $4,200. By getting a quick sale, they could move on to their next deal.

Real estate agents aren’t the only experts who use their informational advantage to their own benefit. I remember hearing about stock traders at Meryl Lynch who, during the bubble, rated companies as “buy” even when they were selling. Why? Because they made more money when people bought more stocks; what monetary incentive was there to be honest?

You may think this sounds outrageous, but remember that ordinary people are no different. Consider internet personal ads. Fat, balding, poor men generally are less successful; so, they avoid posting a picture and stretch the truth a bit.

Whether an expert or a lonely man putting up a person, use their greater knowledge a subject to their own advantage. As the authors state, “The gulf between the information we publicly proclaim and the information we know to be true is often vast.”