"The bad drives out the good", not with Blockchain anymore!

Ever since I was young, I was very intrigued by how the price of a Product or a Service was determined especially when it is competing in an open market with similar Products and Services.  

What really intrigued me was that, as a consumer (buy-side), we are left with no guarantee that the price we pay for a product or service is coherent with its quality among the other competing similar products and services in the Market.

Who among you has never had the bitter experience of buying a product based solely on its price to only realize that it is of lower quality than other similar less expensive products? It happens all the time especially when the buyer or seller initiating the transaction do not have enough information on the market configuration.

Lately, I have been digging in books and academic papers and I found that the situation when one side of the transaction lucks accurate information on the product or service is called “information asymmetry” and that was first described in George A Akerlof paper: The Market for "Lemons": Quality Uncertainty and the Market Mechanism . A must-read piece of paper!

The “information asymmetry” situation, if not properly addressed, can lead to market failure du to “Adverse Selection” (anti-selection problem)  and “Moral Hazard” which are direct consequences of it : “The bad drives out the good”

You see, for markets to flourish, both sides of the transaction (buyers and sellers) need to be able to access trustworthy information used to decide when and with whom to transact. Whenever the “asymmetry of information” situation is too large, markets shutdown, and beneficial trades do not take place.

A Akerlof in his paper, argued that because people buying cars have less complete information about them (engine quality, car’s real Odometer, complete history of the car) than the car seller do, the seller is motivated to sell people cars of less-than-average quality.

At the same time, because most buyers can’t differentiate good cars from bad cars (lemons), sellers of good cars can’t sell them for what they are worth, comparatively. Akerlof referred to this situation as the “lemon problem”.   Information asymmetry” is a shortcoming between two trading parties in their knowledge of relevant factors and details. Typically, that shortcoming means that the side with more information on the product or service enjoys a competitive advantage over the other party. 

“Information asymmetry” pertinent to most types of negotiations and is particularly useful in situations with a design related to game theory, contract theory, which is the field of study of how two parties come to terms of agreement despite unknown factors and unequal knowledge. In the commonest scenario, a seller has more information on the goods or services he offers than the potential buyer.

A vast body of literature in economics has shown us how uncertainty over the quality and trustworthiness of data can have deeply impact on transaction costs, limit the development of markets for products and services, or lead to their failure (Adverse selection, Moral Hazard).

So far, addressing the problems that results from “Information asymmetry” in Market situation induced additional cost: “Third parties providing adequate and verified information to both sides of the transaction to mitigate the risk”.   Third-parties can still add substantial value to marketplaces through data curation, but a revenue model simply based on processing transactions is unlikely to be sustainable in the long run.   Also, this is a trustful solution, meaning that you need to put your trust on the accuracy of the information provided by those intermediaries. Hein! Not enough for me.

Certainly, the Internet as a medium for sharing knowledge helped mitigate the risk of Markets with Asymmetric information but this tends to concentrate more power on the hand of few actors who aggregates all the user generated Data (GAFA). Unfortunately, Internet is no longer decentralized as it used to be.

I think we all agree that we need a solution that sends the right signal (information) to all Market’s participants so they can be assured that they can safely engage in a transaction. Therefore, we can guarantee Markets stability.

What if there is an innovative solution to this long-lasting problem of “Information asymmetry”? A solution that does not impose trust as prerequisite. I think Blockchain can be an important component for building such healthy Markets that can be good for competition and with much less “Information asymmetry”.

First, let’s start by defining the concept of Blockchain relative to a Market configuration:

Blockchain is a paradigm shift in the way we approach  designing economic systems involving multiple peers with divergent interests (~zero-sum game) but find it profitable to be part of the same system (Market)   

The traits of such systems are: 

• Decentralized, governed by rules but without rulers:  By favoring the creation of thick Protocols instead of Platforms like GAFA, the transfer of Value is embedded within the protocol making transactions frictionless, lowering the need for intermediaries. This Thick Protocol layer/Thin Application layer setting lowers the risk of ending up with only small number of players having access to all useful market information.   With all the value concentrated in the Protocol layer, a key cost affected by the Blockchain technology is the cost of networking makes it easy for new actors to enter digital marketplaces and become rapidly competitive. In fact, a permissionless blockchain fueled with a native token can be used to rapidly bootstrap a digital platform without the need to go through a central intermediary.

• Trust is derived from the network not from hierarchy: Another key cost deeply affected by the Blockchain technology is the cost of verification. Trustless systems make it easier to cheaply verify transaction attributes (involved parties, authorization, amounts, history, …) and known to be more “censorship resistant” which makes the market power more distributed across the network.

•  Transactions are fully secured by Cryptography which provides Encryption, Digital signature and especially Authentication.

From this definition, we can conclude that, Blockchain , by design, encourages:  

- Data Transparency by making pertinent transactional information evenly distributed between market actors. 

- Data Immutability which helps maintaining the full history of data in the blockchain ledger and making it accessible to all the market’s participants when transacting with each other.

 - Market inclusion by lowering the cost of networking and verification.  All this helps to make data less asymmetric and therefore markets more secure and efficient, and expand the types of transactions we are willing to engage in: “The good drives out the bad”

In this article I’m not advocating for a 100% information symmetry in a Market configuration because this is simply impossible; Market participants will still prefer to keep some information that will provide them with more competitive advantages, after all, they are here to do business. I’m talking about setting a system that enforces sharing a level of information between all the market participants capable of eliminating the systemic risk of Adverse Selection and Moral Hazard.