Rockstar Economics: How to tackle information asymmetry

One of the most ideal scenarios is economics is a marketplace that has innumerable buyers and sellers transacting on pretty much identical goods with free flowing information about how much someone is willing to buy and what price they are willing to pay for it. Economists term it ‘perfect competition’ where there is no chance anyone – buyer or seller – gets ripped off because as Tim Harford writes in his book ‘The Undercover Economist’:

“…a world of truth leads to a perfectly efficient economy, one in which it is impossible to make someone better off without making someone else worse off.”

But if there are three words economists dread the most, they are – ‘Reality is messy.’ So in truth we have sometimes sellers who know more than buyers (for example, the guy selling you that 2012 Esteem might know of hidden flaws in the car that you don’t) or sellers who have more power over buyers (what if the guy on OLX badly wants to buy a sofa and you come to know that yours is the only one listed there? Would you reconsider the price?). Everyone has their own incentives to keep their cards close to their chest like poker players at a tournament in Las Vegas. Producers try to keep their cost structure secret from a regulator forcing them to set prices. Doctors or clinics might not always provide you an itemized bill of their charges. You might not tell your insurance company that you used to smoke till last New Year’s.

The essence I am trying to get at is that you will always have transactions everyday where you have incomplete information or to use the economists’ term ‘asymmetric information’. These things make a fair transaction difficult, if not impossible. How does one level the playing field?

The answer may lie in this quote from Dr. Gregory House, the iconic character played by Hugh Laurie in the popular TV show, House MD:

“I’ve found that when you want to know the truth about somebody; that somebody is probably the last person you should ask.”

That’s actually a brilliant piece of advice. Which is why we have websites that help us read reviews of restaurants before we visit one or compare the fair prices of 2012 model Esteem cars before we commit to our seller and her price, or banks being able to pull up your credit history before they grant you a loan.

And this where, in our story, the rock band that Eddie Van Halen founded come in. Van Halen were a huge act in the 1980s. They were brilliant live performers and their concerts were always sellouts. During those days they had a very notorious clause in their technical rider – the document that lays out technical requirements for bands at concerts – their dressing room should have a bowl of M&Ms the sugar coated colourful candy but there should be ABSOLUTELY no BROWN M&Ms. Their manager and frontman David Lee Roth would throw a fit if the bowl had brown M&Ms. Why would a rock band care about the colour of their candy in a contract? Was it just typical rockstar excess and tantrums? Not quite.

The famous clause from a famous rider.

As David Lee Roth later revealed, their Brown M&M clause was not a whimsical rockstar request. It was a clever test to figure out if the event managers at their concerts had read their technical rider completely which talks about complicated set ups needed for their performance. If they saw brown M&Ms in the bowls backstage, they would know it hasn’t been thoroughly read and would do a double check of the arrangements because no event manager would admit to not having read the rider and might even lie outright causing a major problem for the band and their fans if the equipment did not work properly.

Van Halen were trying to combat the principal-agent problem.

Van Halen were trying to solve what in economics we call a principal-agent problem. It arises when there is “a conflict in priorities between a person or group and the representative authorized to act on their behalf”. The concert organisers in this case could be the agents acting on behalf of the principal, Van Halen. Typically the agent has more information than the principal – the asymmetric information issue I mentioned earlier. The upshot is that the principal cannot always ensure that the agent acts in the principal’s best interests. This departure from the principal’s interest in the agent’s interest is called an “agency cost.” Thus, they need to devise ingenious solutions to overcome those irritants that create costs and obstacles when a principal deals with an agent.

And as the rock band Van Halen will tell you, it can be fun too.