Asymmetric Information Economics Lecture

1.0 Adverse Selection

Adverse selection is an economic concept that frequently appears in the literature for insurance and risk management. The main idea is that buyers and sellers have different or asymmetric information about goods, financial instruments or products, and those traders with better information about product quality will selectively participate in trades which benefit them the most—at the expense of their counterparts. The concept also exists in a more general sense of imperfect information between parties in any exchange and in any human action undertaken. Several Nobel laureates have published work related to asymmetric information, including Friedrich A. von Hayek, George Akerlof, Douglass North and Michael Spence, who are cited in this chapter.

Buyers with low time preference can take advantage of supermarket sales and “loss-leaders” by going from store to store in town and buying virtually only those sale items at each one—even though it takes many hours to do so. Supermarkets do not, of course, generally know the time preferences of customers and can hardly exclude them from buying sale items. Thus, in the business’ calculations, they must consider losses incurred from such customers. Another business that can possibly lose business on time preference are currency exchange houses, especially if they are near competitors. People with time on their hands will be willing to walk from shop to shop until they find the best prices. Low-price fuel shoppers do the same thing.

The same is true of steakhouses that offer a free four-pound steak, potato and salad dinner for those that can clean their plates (otherwise they pay dearly for the meal). The restaurant hopes to make more money on those that try and fail than those that rise to the feat. All-you-can-eat buffets face similar asymmetries, as do life and health insurance companies, since unhealthy people will presumably be more likely to buy those products. Each industry has its own tried-and-true methods to avoid getting “taken” by “bad” customers.

For instance, the life insurance is the largest category of insurance sold in the United States, and research has shown that companies have been relatively successful in overcoming information asymmetries (Cawley & Philipson 1999), as have automobile insurers in France (Chiappori & Salanie 2000) and group health insurers in the United States (Cardon & Hendel 2001; Cutler & Zeckhauser 1998). However, the same is not true for health insurance in the United Kingdom (Olivella & Vera‐Hernández 2013), long term care insurance in the United States (Finkelstein & McGarry 2006), certain annuities (Finkelstein & Poterba 2004), or homeowner’s insurance in Florida (Dionne, Gouriéroux & Vanasse 2001).

Many other studies in the insurance industry have been done that suggest that informational asymmetries are not a great problem in the insurance industry (de Meza & Webb 2001), and at times they tend to be mitigated by “propitious selection” (Hemenway 1990) so as to become “favorable selection” instead of adverse selection. Indeed, some scholars have concluded that the presences of small doses of asymmetric information is actually beneficial for the insurance market (Thomas 2008)—even generating a “welfare-enhancing effect of private information” as a “consequence of the fact that sellers’ price-setting behavior is in line with adverse selection theory” (Hoppe & Schmitz 2015).

This theory is connected by the wider, devastating critique of central planning, which cannot work simply because no single mind or committee possesses the “fragmented” and “dispersed” social or economic information needed to plan correctly (Hayek 1945; Sowell 1996; Holcombe 1995; Cobin 2009: 242-250). Some have thus been led to consider asymmetric information to be a “market failure.” The basic tenet of this premise is that since markets do not perfectly inform buyers and sellers about any transaction or good traded, they fail, with the presumption being that Pareto-efficient or Pareto-preferred public policy can be enacted to mitigate this malfunction.

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1.1 Market for Lemons

The classic example of asymmetric information was presented in Akerlof's “Market for Lemons” paper (1970), which, curiously, was rejected by three major journals before finally being published (Gans & Shepherd 1994: 171). He argues that the quality of goods can decline under conditions of information asymmetry between buyers and sellers, such that only “lemons” remain, e.g., a used car or other good that is found to be defective after it has been purchased. On the one hand, imperfectly informed buyers often cannot distinguish between a high-quality used car or other good and a “lemon,” no can they easily know the history of the used good in question. Knowing this fact, they choose to pay a price for a car that is fixed between a good one and a lemon.

On the other hand, sellers know often whether the product for sale is a lemon, and will only sell it to those buyers with an intermediate price, never offering higher-quality goods at that discount. For instance, the owner of a carefully maintained, never-abused, good used car will be unable to get a high enough price to make selling that car worthwhile. However, the owner of the opposite quality used car will happily do so.

Eventually, as enough non-lemon sellers leave the market, the average willingness-to-pay of buyers also will decrease, given that the average quality of remaining goods in the market has decreased, such that the market quality continues its downward spiral. As a result, the pricing strategy by uninformed buyers creates an adverse selection problem that drives higher-quality goods from the market, perhaps resulting it is eventual collapse. The result is that in a market with asymmetric information with respect to quality, will have characteristics similar to those described by Gresham's Law: the bad drives out the good. In order to address this problem, firms adapt by varying prices according to different qualities (Phlips 1983: IV).

However, subsequent studies questioned the veracity of lemons problems and asymmetric information in markets. “The economic literature is divided on whether a lemons market actually exists in used vehicles” and public policy to correct the market’s “failure” to provide information itself failed in Wisconsin. Indeed, the “known defects provision,” has been ineffectual; the mix of used vehicles traded there did not have significantly better quality than in neighboring states without corrective such legislation (Hoffer & Pratt 1987).

1.2 Imperfect Information as Market Failure

The knowledge problem provides a new critique of welfare economics. Indeed, “the sum total of knowledge available in an economy ‘never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.’ It follows that nobody—and that obviously includes the government—is able to take a God's eye view of economic or social life. Politicians should be humble and cautious when they attempt to make decisions on behalf of the community as a whole because they rarely, if ever, possess enough knowledge to make the right decisions” (Prowse 2014). On the one hand, government regulatory schemes are invariably fettered by the knowledge problem. On the other hand, market-regulatory institutions can alleviate information asymmetries through men acting under rivalrous competition.

Ignorance or imperfect information—the very thing assumed away in static models—is precisely the object that allows entrepreneurial profit. “A state of market disequilibrium is characterized by wide-spread ignorance. Market participants are unaware of the real opportunities for beneficial exchange which are available to them in the market. The result of this state of ignorance is that countless opportunities are passed up” (Kirzner 1973: 69). So, are informational asymmetries really “failures?”

Consumer ignorance certainly leads them to make suboptimal choices at times. The market becomes the culprit for producing socially-unacceptable results, particularly when a firm or person deceives another to their hurt (e.g., buying defective or faulty goods, or potentially hazardous components known only to the seller). Likewise, third parties may suffer injury due to production flaws generated by the actions of others.

In order to avoid such pitfalls, consumers often demand insurance, grading, certification, and other informational services to guarantee—or at least assure—the quality of goods purchased, or to minimize the risks associated with a transaction. The theory of market failure contends that the existence of information asymmetries implies a market failure that should be partially or wholly alleviated by proactive public policies or public policies of inefficient provision of goods and services normally provided by markets (e.g., mails, automobile mechanics).

Nevertheless, there is a growing body of evidence (Cobin 2014a; Holcombe 1995) that firms specializing in information services will spontaneously develop in markets. They will secure discipline in the market or “catallaxy” which encourages firms and individuals to build and maintain upright reputations.

1.3 Framing Contracts

Along with strong property rights, the legal institution of contracting, which spells out the “rules of the game” for economic actors (North 1992), facilitates exchange and, when done well, dramatically reduces transactions costs. However, no contract eliminates informational asymmetry problems entirely, even though contracts have improved over time through legal trial and error. “In reality it is usually impossible to lay down each party's obligations completely and unambiguously in advance, and so most actual contracts are seriously incomplete” (Hart & Holmström 1987: 112).

The literature on contracting suggests that contractual forms have large effects on behaviour. Incentives matter. Curiously, the marketplace is full of “fairly simple contracts” (Chiappori & Salanie 2002: 34), that leave open the potential for greater transactions costs in the future. Evidently, the expected costs of such things occurring is less than the expected benefits accrued from forming better contracts. The field of law and economics has its core objective to incorporate economic concepts such as information asymmetry, moral hazard, and adaptation to changed circumstances, in the interpretation and analysis of contracts and disputes, as well as to develop a contract doctrine (Goldberg 2012).

Some of the fascinating topics of contract framing studied by economists include screening, signalling and moral hazard. In addition, multilateral contracting, long-term contracting and bilateral trade with private information (hidden action), auction theory, plus the internal organization of firms, incomplete contracts, the theory of ownership and control, and dealing with externalities (Bolton & Dewatripont 2005).

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1.4 Signalling

Sellers beleaguered by adverse selection will try to protect themselves by screening customers or by identifying credible quality “signals.” In contract theory, signalling means that an agent credibly conveys information about himself to a principal. For example, prospective employees send signals to potential employers about their ability levels by obtaining education credentials (Spence 1973; Weiss 1995; Hungerford & Solon 1987)). The value of doing so resides in the fact that employers believe that such education is positively correlated with greater ability, since it is difficult for lower-quality employees to attain. Thus, it enables employers to reliably distinguish lower-ability workers from higher-ability ones.

Signalling blossomed alongside the theory of asymmetric information within economic transactions. Inequalities of access to information twists “normal” market exchange. However, parties involved in trade can circumvent asymmetry problems if one party sends a signal that reveals a bit of relevant information to the other (Spence 1973). That party interprets the signal and adjusts purchasing decisions accordingly—perhaps bidding up the pre-signal price, and thus resulting in many ancillary problems.

The amount of time, energy and money that the sender (or agent) should spend on sending a signal will depend on how much the receiver (or principal, usually the buyer) can trust the signal to be an honest revelation of information. In many cases, equilibrium conditions will arise, until such time that trust breaks down.

Even in online markets, where information is quite asymmetric, especially for vehicles, markets have developed to help consumers trust the information they see on the web, and give sellers confidence that their sale will be realized. In fact, “information signals (diagnostic product descriptions and third-party product assurances) reduce product uncertainty” (Dimoka, Hong & Pavlou 2012). Moreover, “the volume of trade in these markets proved so robust to adverse selection” (Lewis 2011: 1535)—eBay Motors for instance, the largest used car market in the United States. Furthermore, Internet sites that do not specialize in brand name products can successfully attract customers by increasing reputation through participation in “price comparison sites” (Waldfogel & Chen 2006). Thus, as technology increases, so does the impact of signaling.

1.5 Moral Hazard

In economics, a moral hazard occurs when one person takes greater risk (e.g., does not lock his doors) because someone else (usually an insurer) bears the cost of the increased risk. Moral hazard situations are most frequently seen after financial or insurance transactions are completed, wherein the actions of one party change to the detriment of another (e.g., a claim must be paid).

Moral hazard arises especially when information asymmetries between buyers and sellers occur, where the soon-to-be risk-taking party to a transaction knows more about his intentions than the party paying the consequences for his behaviour. In such situations, the party with more information about intended actions has an incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard theory implies that welfare payments, unemployment insurance and workers’ compensation should not be too generous, since recipients will tend to abuse the system and remain unemployed rather than work (Dewan 2012). They might also work in more informal markets to supplement the handouts or “insurance” payments they receive. Members of the press, usually dominated by the political Left, have led the charge against moral hazard theory being applied to public policy—especially health care (Gladwell 2005). But they also make a very good point that wealthier people do not necessarily consume more health care just because the marginal cost of doing so is low for them, any more than they consume more coffee than poorer people just because it is a relatively small portion of the household budget constraint. Thus, moral hazard has its limits.

The same must be true of fire insurance. People are probably not going to risk their lives by “not worrying too much” if their house burns down since it is insured. It is more likely that houses will burn down due to ancillary problems arising from rent seeking and regulatory capture that make hazards greater or building materials less safe or less-efficiently installed, than they will burn down from carelessness (Cobin 1997; 2000; 2013a; 2013b; 2013c; 2014b). Aside from politics, logic suggests that moral hazard must have its natural limits.

Buying life insurance before committing suicide, in order to benefit one’s loved ones is an example of such behavior. For that reason, life insurance contracts usually have a contractual clause that excludes payments of death claims resulting from suicide for two years after the issuance of the policy. The same thing can be said for preexisting conditions and exclusion clauses in health and disability insurance, leading some to criticize the use of moral hazard theory in insurance industry practice (Baker 1996: 291-292).

Moral hazard also arises within the principal-agent problem, where the agent (or manager), acts on behalf of another (the principal). The agent usually has greater information about his actions and intentions than the principal does, since it is difficult for him to monitor the agent (Laffont & Martimort 2002: 147-148). Accordingly, the agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of both are not aligned. This is especially true between stockholders and management, where the latter tend to be risk-averse and do what is necessary to maintain their posts with higher salaries, rather than take greater risks for the firm that would tend to increase shareholder’s returns. It is also supposed that physicians have an advantage over patients, who can only with great difficulty determine their level of knowledge and skill (Arrow 1963: 967; 1971).

“Moral hazard describes a situation in which a party is insulated from the consequences of its actions. Thus protected, it has no incentive to behave differently” (Ahrens 2008). The same thing occurs when financial or automaker firms (and their shareholders) know that the government will “bail them out” if they face regrettably consequences due to risky decisions. The government is in effect an insurer. However, the existence of moral hazard might actually improve contractual provisions and thus reduce uncertainty and transactions costs (Holmstrom 1979: 89-90).

2.0 Law and Economics

Economists study human action aiming at consistent ends by efficient means, including the use of institutions that minimize costs and uncertainty, such as the law. Judges and lawyers are expected to act rationally, and will be criticized otherwise. Economic models are thus useful in explaining law, legislation, and legal institutions.

2.1 Law Versus Legislation

Importantly, law, as a spontaneous order, differs from legislation. The law is the embodied evolution of useful legal designs which have been adopted by societies of acting men, increasing social knowledge over time while undergoing a process of evolutionary improvements through marginal changes to customs.  Accordingly, law is not invented by the state. It arises spontaneously as a consequence of human action striving to find institutions that alleviate uneasiness and engender cooperation that makes civilization possible. However, legislation is artificial “law” decreed by states—not to be confused with antecedent law (Hayek 1973: 72). Judges play a role in distributing the law (119). In the end, law precedes society and the state, just as do property rights and individual rights (95).

Customary law, rather than legislation, is still used today to facilitate human action, and is thus more powerful than legislation in attaining social order (Benson 1990: 230). Unlike legislation, it requires voluntary acceptance within society to have force and effect. In summary, there is a difference between law and legislation, each of which has distinct origins. On the one hand, legislation is subject to inefficiencies due to lack of knowledge and public choice problems, and is thus more distortive to human action by injecting inefficient transaction costs into the market process. Ideological-driven divorce policy which caters to special interest groups that profit from it (e.g., lawyers, judges, feminist activists, forensic psychologists and social workers) is perhaps the most glaring example of a legislative social distortion (Baskerville 2007; 2008). On the other hand, law reduces information costs, facilitating cooperation.

2.2 The Injection of Economics into Law

Until recent decades, law did not make use of economics, except in the areas of antitrust, regulated industries, taxes, and the determination of legal liability settlements. Now it has been extended into the traditional areas of the common law: property, contract, and tort, forever changing the nature of legal scholarship and the common understanding of legal rules and institutions (Cooter & Ulen 1997: 1-2). For economists, legal sanctions are like prices and people respond to them in a similar manner as they respond to prices. Consequently, people consume fewer legal “goods” and services their prices or expected legal penalties rise and become more severe. This fact, makes human behaviour more predictable and directable. However, when legislation-induced distortions are introduced, costs and uncertainty rise, making costly penalties ever more severe.

In terms of production, companies have two interesting costs to consider in terms of potential legal sanctions: product safety (i.e., design costs), plus the present value of implicit costs of awards made to clients who will be injured by using their products, which is largely unknown if it is a function of activist legislation. Such damages are determined in the judicial process. Consequently, firms compare the expected costs of production with the expected benefits in order to maximize profits. This result is attained by the producer when he adjusts the level of safety until the real cost of additional product safety is equal to the implicit price of the added accidents that will occur by increasing production and, by implication, consumption (Cobin 2009). Thus, economic theory predicts how people will respond to changes in law or legislation. If law and legislation can be utilized to achieve social goals, economics can predict public policy’s effect on efficiency, and improve the efficiency of contracts (Cooter & Ulen 1997: 3, 5).

2.3 Common Law Versus Civil Law

Unlike legislation, law reduces costs by making life more predictable. Cost considerations are crucial in personal and business decisions, making it useful to analyze the efficiency of law, legislation and regulation. The law is a spontaneous order that incorporates minor marginal changes over time, which lends itself to the sort of marginal analysis performed by economists.

Two legal traditions have stood the test of time: the common law of property, contract, and tort (in most of the former British Empire or where English is spoken), and the civil law (in the most of the rest of the world). The former is slightly more efficient and predictable since rules change slowly and slightly. Rulings are justified through precedent and social norms (Cooter & Ulen 1997: 56-57). If no precedent is presented in a dispute, judges create one, giving them an opportunity to change the common law (Cooter & Ulen 1997: 65). In terms of economics and development, many nations are backwards due to their poor legal systems (Mises 1966: 499-502) and the many public choice caveats that appear along the way via idealistic legislation. Mises argues:

“The start which the peoples of the West have gained over the other peoples consists in the fact that they have long since created the political and institutional conditions required for a smooth and by and large uninterrupted progress of the process of larger-scale saving, capital accumulation, and investment. Thus, by the middle of the nineteenth century, they had already attained a state of well-being which far surpassed that of races and nations less successful in substituting the ideas of acquisitive capitalism for those of predatory militarism. Left alone and aided by foreign capital these backward peoples would have needed much more time to improve their methods of production, transportation, and communication”
- (Mises 1966: 497).

He also notes that Western prosperity is the result of a legal system founded upon reason and more effective cultural institutions:

“[T]he temporal head start gained by the Western nations was conditioned by ideological factors which cannot be reduced simply to the operation of environment. What is called human civilization has up to now [1949] been a progress by cooperation by virtue of hegemonic [dominance or ascendancy] bonds to cooperation by virtue of contractual bonds. But while many races and peoples were arrested at an early stage of this movement, others kept advancing. The eminence of the Western nations consisted in the fact that they succeeded better in checking the spirit of predatory militarism than the rest of mankind and that they thus brought forth the social institutions required for saving and investment on a broader scale...What the East Indies, China, Japan, and the Mohammedan countries lacked were institutions for safe-guarding the individual’s rights. The arbitrary administration of pashas, kadis, rajahs, mandarins, and daimos was not conducive to large-scale accumulation of capital. The legal guarantees effectively protecting the individual against expropriation and confiscation were the foundations upon which the unprecedented economic progress of the West came into flower. These laws were not the outgrowth of chance, historical accidents, and geographical environment. They were the product of reason (Mises 1966: 500).

2.4 The Coase Theorem and Its Use to Justify Judicial Activism or Interventionism

The Coase Theorem (Coase 1960) became the unintended route by which the West has fallen into judicial activism and policy uncertainty through the courts, which frequently deal with negative externalities. The Theorem says that where the costs of concluding a contract are low, the rule of law will not affect the level of negative externalities like pollution because people will have already found cooperative, efficient solutions. “Given free bargaining and low transactions costs, voluntary actions of individuals in the market will allocate property rights to their most highly valued and efficient use. Both parties in a dispute over property rights have an incentive to move to this position. Such allocation occurs automatically without regard to how property rights are initially or legally assigned. Judicial action to allocate them generates a superfluous social cost and is itself a negative externality” (Cobin 2009: 427). “It is necessary to know whether the damaging business is liable or not for damage caused, since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost” (Coase 1960: 8).

Thus, when there is low transactions cost bargaining between parties, judges will not be able to change the level of negative externality. The Coase Theorem says that the individual actions in the market will allocate property rights to their highest valued or most efficient use. Efficient allocation occurs automatically, no matter how property rights are initially assigned by a court. The activity of judges in such cases, therefore, creates a negative external cost to others, amounting to a superfluous cost to society in general.

However, when transactions costs are high enough to impeded private bargaining, which is often the case, judicial activism with the goal of finding the efficient solution become necessary. Thus, many judges now study economic modes in order to make more efficient rulings. The inverse use of the Coase Theorem thus suggests that under conditions of high transactions costs and/or barriers to free market exchange, court can improve property rights allocations. By assumption, there must be high transactions costs or some market impediment involved if people have gone to the trouble and expense to litigate a problem. Judges, like Richard Posner, may perceive a mandate to find out the source and the amount of inefficiency from a negative externality, and then determine what measures should be taken to remedy it—even if that means strictly interpreting and enforcing a rule in contract or property rights law (Posner 1992; Pound 1942). Judges become guardians of social welfare, even abrogating or severely modify the plain meaning of contracts and override property rights, in favor of whatever they deem is best for the “public interest.”

Fortunately, there are several real-world examples that demonstrate both Coasean bargaining and spontaneously-emerged market grading institutions. The rare coin grading industry provides perhaps the most important, pure market example of how buyers and sellers eliminate information asymmetries by using market-based (rather than government) regulation. The following case is based on excepts from John Cobin’s study, “Rare Coin Grading: A Case of Market-Based Regulation” (Cobin 2014a), which provides a pure example of market-based regulation (without the slightest policy intervention) that serves to alleviate asymmetric information. Note: the complete article with table data is viewable online at the Cato Journal website.

3.0 Example: Case of Rare Coin Grading Industry

Government regulators face different incentives than private ones, which impel them to be inclined to overlook quality difficulties. Public choice problems and the knowledge problem—with asymmetric information—preclude government regulation from effectively producing better quality (Holcombe 1995). Bureaucrats have come under special scrutiny in the last fifty years (Niskanen 1971; 1994; Simmons 2011), even to the point of questioning if they work to serve the public interest (Buchanan 1991: 37).

Accordingly, market-based regulation emerged as a remedy for government failure (Alger & Toman 1990; Blundell & Robinson 2000; Cobin 1997; 2013a; 2013b; 2013c; O’Driscoll & Hoskins 2006; Poole 1982; Benson 1989). When competition and concern for reputation are present, markets will spontaneously emerge to efficiently regulate the quality of goods and provide consumers with lacking information (De Alessi & Staaf 1994, Klein 1997, Komhauser 1983, Shapiro 1983).

There are many cases of effective private regulatory alternatives: free banking (without a central bank or its regulation), currency emission, arbitration and customary law, brand name generation, approval seals like Good Housekeeping, and quality certifiers like Dun & Bradstreet and Underwriters Laboratories (O’Driscoll & Hoskins 2006). More of such institutions would exist, except that the government crowds them out: “With this illusion of a government umbrella protecting everyone from harm, there is relatively little public demand for private regulation” (Holcombe 1995: 103-104). Grading and certification services for sports cards (Dobrow 2014) and gemstones (Cobin 1997: 105-6) are even better examples of market-based regulation, too.

Nevertheless, the rare coin industry is the most lucid example of market-based regulation. It serves a vibrant and large market (Milburn 2013), where a single coin can sell for several million dollars. Annual sales run into the billions (excluding unreported transactions). Returns on rare coin investments exceeded fifteen percent annually on average from 1970-90, and rare coin sales skyrocketed to nearly US$1 billion annually by the late 1980s (Allard 1990: 279).  Today sales exceed US$10 billion, per the CoinTrackers website. Indeed, rare coins have been one of the top-performing investments in the last several decades, with some Wall Street firms even developing limited partnership interests in rare coin portfolios and a rare coin index to track the market (Allard 1990, Milburn 2013).

The existence of private inspectors and certification firms which are employed by lenders, insurance companies, and consumers, show that private industry provide market regulatory alternatives that alleviate negative externalities and improve social knowledge. Since 1986, the rare coin industry has generally accepted a system in which uncirculated coins are graded by one of many independent organizations that assign numerical standards based on appearance.  The U.S. system established by the American Numismatic Association is the most widely used. The two most important, well-respected and prestigious firms are Professional Coin Grading Services (PCGS, founded 1986) and Numismatic Guaranty Corporation (NGC, founded 1987)..

Rare coins are valued according to both their rarity and their grade. “Proof” (PR or PF) refers to the method of manufacture and the condition is usually perfect uncirculated. Uncirculated levels above “borderline or brilliant uncirculated” (BU) are also referred to as “mint states” (MS).  A corresponding numerical ranking system now predominates, with the lower grades of coins being assigned numbers from 1 to 49, and “about uncirculated” (AU), BU, and MS grades of coins receiving numbers from 50 to 70 (Yeoman 1994: 5).  The technique for grading coins was standardized by the end of the 20^th century (Halperin 1990), providing a means to identify the rarest and most valuable coins. According to the PCGS website, there are fifteen very rare, graded U.S. coins worth between US$4.5 million and US$15 million each.

Grades from 60 to 70 are reserved for a “perfectly preserved coin” (Allard 1990: 279). In general, other than perhaps a handful of exceptionally rare coins, only coins with grades of MS-60 (a.k.a. “BU”) to MS-67 are actively traded as investments.[1]

A coin’s grade is affected by authenticity, luster, strike, color, toning, friction, coin or die flaws, and obverse/reverse grade consolidation (Martin 2008). Rare coins are slabbed—i.e., encapsulated—by grading firms into acrylic holders to protect the coins, and their grade is certified in the casement, which also indicates the firm name and coin type. The grade is invalidated if the casement is tampered with. Daily market quotations enable rare coins dealers to trade with increased knowledge, reliability and verifiability (Allard 1990: 279).

Dealers and consumers benefit from the existence of numerous newsletters, reports, catalogs, and pricing guides, which provide contributive analyses and recommendations (Allard 1990: 284-85). These publications include the Coin Street Journal, Coinage, COINfidential Report, Coins, ANS Newsletter, The Numismatist, Numismatic News, Coin World, COINage Magazine, and World Coin News. Services provided by rare coin grading and certification firms include grading, authentication, photo certification, encapsulation, and low-cost, comprehensive insurance (Cook, Cribb & Carradice 1990: 7). Major firms in North America, Europe and Asia provide some or all of these services.

Publications provide average percentage of “sheet price” (see table below) paid for a coin by dealers when the coin purchased is unseen—i.e., by telephone or the Internet. The percentage is an excellent proxy for reputation, since it reflects the relative confidence that dealers have in the slabbing firm’s ability to grade a coin correctly (higher percentages correspond to better reputation in the market). Thus, buyers can easily assess the value of the information produced, and to judge whether a firm is reliable.

Top Coin Grading Firms’ Reputation Ratings (Source: Coin Dealer Newsletter, Cobin 2014a)[2]

Firm	--------- Greysheet Rating ----------
	November 12, 1994		November 29, 2013		Percentage Change
PCGS	98	83.1		−15.2
NGC	89	82.9		−6.9
ICG	n/a	65.7
ANACS	74	65.2		−11.9
PCI / DGS	84	52.1		−38.0
SEGS	n/a	47.6
NCI	42	42.5		+1.2
INS	43	34.0		−20.9

Consequently, inexperienced buyers can now purchase coins that have been graded and authenticated by third-party services to assure the quality of each item. There is more written information available for beginners than ever before. The industry has done a credible job of upgrading the quality of services provided by coin dealers through organizations and associations that promote strong professional conduct and ethics (Yeoman 1962: 6). Grading services in the rare coin industry demonstrate that the market process has successfully made provision for setting standards and regulating quality without any reliance on government. Market-based regulation is not only possible, it is likely; and it emerges without public policy to satisfy consumer demand efficiently.

4.0 References

Ahrens, F., 2008, ‘“Moral Hazard”: Why Risk Is Good’, The Washington Post, 19 March, viewed 8 November 2016, from http://www.washingtonpost.com/wp-dyn/content/article/2008/03/18/AR2008031802873.html.

Akerlof, G.A., 1970, ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’, Quarterly Journal of Economics 84(3), 488-500.

Allard, D.M. (Ed.), 1990, Hobbyist Sourcebook, Gale Research: Detroit.

Anderson, R.K. & Enomoto, C.E., 1986, ‘Product Quality and Price Regulation: A General Equilibrium Analysis’, Economica 53(29), 87-95.

Arrow, K., 1963, ‘Uncertainty and the Welfare Economics of Medical Care’, The American Economic Review 53(5), 941-973.

Arrow, K., 1971, Essays in the Theory of Risk- Bearing, Markham, Chicago.

Baker, T., 1996, ‘On the Genealogy of Moral hazard’, Texas Law Review 75: 237.

Baskerville, S., 2008, ‘From Welfare State to Police State’, The Independent Review 12(3), Winter, 401-422.

Baskerville, S., 2007, Taken into Custody: The War against Fatherhood, Marriage, and the Family, Cumberland House Publishing, Nashville, Tennessee.

Benson, B.L., 1990, The Enterprise of Law: Justice Without the State, Pacific Research Institute, San Francisco.

Benson, B., 1989, ‘The Spontaneous Evolution of Commercial Law’, Southern Economic Journal 55(3), 644-161.

Blundell, J. & Robinson, C., 2000, Regulation without the State: The Debate Continues, Institute of Economic Affairs, London.

Bolton, P. & Dewatripont, M., 2005, Contract Theory, MIT Press, Cambridge Massachusetts.

Buchanan, J.M., 1991, ‘From Private Preferences to Public Philosophy: The Development of Public Choice’, in Constitutional Economics, Basil Blackwell, Cambridge, Massachusetts.

Cardon, J.H. & Hendel, I., 2001, ‘Asymmetric Information in Health Insurance: Evidence from the National Medical Expenditure Survey’, Rand Journal of Economics 32(3), 408-427.

Cawley, J. & Philipson, T., 1999, ‘An Empirical Examination of Barriers to Trade in Insurance’. American Economic Review 89(4), 827-846.

Chiappori, P.A. & Salanie, B., 2000, ‘Testing for Asymmetric Information in Insurance Markets’. Journal of Political Economy 108(1), 56-78.

Chiappori, P.A. & Salanie, B., 2002, ‘Testing Contract Theory: A Survey of Some Recent Work’, CESifo Working Paper Series 738, viewed 8 November 2016, from https://ssrn.com/abstract=318780.

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[1] Sometimes a + symbol will be added to the grade to indicate that it is close to another level. Higher grades from MS-68 to MS-70 are extremely rare or do not exist for most collectible, non-bullion coins.

[2] The rating is the average percentage of “sheet price” paid for an unseen coin, with a range of ±15 percent for the four better firms, and as much as ±32 percent for the others. The “greysheet” is jargon for a price list of slabbed and “raw” coins found in the Coin Dealer Newsletter.