Information asymmetry

Imagine you're on a road trip in the middle of the United States, far from any major city. It's getting late, and you need to stop somewhere for food. You see a sign for a gas station and rest area, so you take the next highway exit and enter a small town that appears to be lost in the 1980's.

You slowly drive by a diner of some sort with a few pickup trucks parked out front, and you see a couple of teenagers smoking and skateboarding in the parking lot. The signage on the restaurant is faded - does it say "Timmy's Diner" or "Tommy's Diner"?

Reluctant to make a rash decision, you drive around a bit more since you could always circle back. A block or two later, you catch a welcome sight in the distance: the familiar golden arches of a McDonald's restaurant.

Let's be honest - given these two options for dinner, which would you choose?

I would choose the McDonald's. Most people would probably do the same. This is information asymmetry at work. That diner might have the best burgers in the state, but we wouldn't know that. So instead, we choose an option that - while never great - will never disappoint us too badly.

(Note that this classic example is a bit outdated. Those with at least some tech savvy could just check Yelp these days to find out whether the diner is any good. That said, are Yelp ratings even trustworthy anymore?)

Information asymmetry still exists today - especially in areas where we can't entirely trust what Internet research might tell us.

For example, recently, my family has been looking for early childhood education options for my daughter. My wife took her to the local Gymboree for a trial lesson sometime ago, and the last couple of days, the salesperson has gotten increasingly persistent. The last package they quoted was 225RMB per 45 minute lesson - but with the catch that we need to purchase a minimum of 60 lessons.

I suspected this was overpriced, so I asked a friend who has two young kids. He shared the place he takes his kids to - a small music and play studio called Jitterbugs with five locations across Shanghai that's run by a French lady. My friend clearly likes it since he continues to take his kids there. The price? 100RMB per 45 lesson, with no minimum purchase (we can buy one lesson at a time).

A lot of value creation in the economy is priced significantly above the cost to produce or deliver that value. There are a number of reasons that explain why this is the case.

Salespeople are needed to sell the product

Think about the aggressive ones that work at Lianjia, local gyms, or education companies and persistently call to try and make their monthly sales targets. A sales force costs (a lot of) money to maintain.

The appearance of credibility (to increase conversion rates) is also expensive - think of all the professional services firms that lease very expensive offices in the city center. Just as a real estate agent might drive a luxury car to appear successful to prospective clients, a consulting firm rents an office in the city's most expensive area for the same purpose.

The company spends a lot on advertising

FMCG companies such as Coca-cola and Procter and Gamble were built on advertising, which builds brand equity for their products. For P&G, brands such as Crest or Gillette or Pantene are probably no better than most competing products, but in the world of consumer goods, recognition of these iconic brands is what drives sales. (Meanwhile, Coca-cola spends $4 billion per year - more than 10% of its annual revenue - on advertising each year.)

The company is huge and has many layers of management

Managers don't deliver any direct value; instead, their main job is to ensure that others are delivering value - and they get paid a lot to do this.

I'd estimate that a typical corporation has five people reporting to each manager, and each manager is paid approximately twice as much as the people reporting to them.

Let's do some math with the above assumptions. If we have 625 front line employees creating direct value for customers and they're paid 10,000RMB per month (for a total of 6.25 million in payroll), then there would be 156 managers (125 + 25 + 5 + 1) who would be paid a total of over 4 million. Therefore, a corporation with this management hierarchy would spend nearly 40% on managers alone.

What can we do to minimize the impact of information asymmetry? I think the best way is to become acquainted with people from a wide range of industries. If you need a restaurant recommendation, ask a foodie and share with them your cuisine preferences. If you're looking for a wedding photographer, consult with a photographer friend for referrals (or perhaps just recruit your friend).

Barring that, there are some rules of thumb that might be good to follow if the stakes are high and we need exceptional quality or service:

• Avoid big companies that cannot leverage economies of scale well. Examples include large professional services firms (eg. the Big Four) and chain restaurants (eg. McDonald's). This doesn't apply to most technology companies (eg. Apple) since they can dump all their resources into creating a few products each year that are differentiated from everything else on the market.
• Be wary of salespeople who look like salespeople. The best sales is hidden. To paraphrase Peter Thiel, this is why salespeople in most industries are called different things: account executives sell advertising; investment bankers sell companies; and politicians sell themselves. Mr. Thiel gives the example of tech executives in suits. Anyone who wears a suit is likely to be bad at sales and worse at tech.
• If possible, do your own due diligence and find a small company with good reviews that doesn't advertise its products and/or gets most of its business from referrals. In my mind, I'm thinking of a small Japanese restaurant or hot springs resort that has existed in the same location for generations. These tend to deliver the best quality.