Freakonomics Revised and Expanded Edition

by Steven D. Levitt

  Information is a beacon, a cudgel, an olive branch, a deterrent—all depending on who wields it and how. Information is so powerful that the assumption of information, even if the information does not actually exist, can have a sobering effect. Consider the case of a one-day-old car.

  The day that a car is driven off the lot is the worst day in its life, for it instantly loses as much as a quarter of its value. This might seem absurd, but we know it to be true. A new car that was bought for $20,000 cannot be resold for more than perhaps $15,000. Why? Because the only person who might logically want to resell a brand-new car is someone who found the car to be a lemon. So even if the car isn’t a lemon, a potential buyer assumes that it is. He assumes that the seller has some information about the car that he, the buyer, does not have—and the seller is punished for this assumed information.

  And if the car is a lemon? The seller would do well to wait a year to sell it. By then, the suspicion of lemonness will have faded; by then, some people will be selling their perfectly good year-old cars, and the lemon can blend in with them, likely selling for more than it is truly worth.

  It is common for one party to a transaction to have better information than another party. In the parlance of economists, such a case is known as an information asymmetry. We accept as a verity of capitalism that someone (usually an expert) knows more than someone else (usually a consumer). But information asymmetries everywhere have in fact been gravely wounded by the Internet.

  Information is the currency of the Internet. As a medium, the Internet is brilliantly efficient at shifting information from the hands of those who have it into the hands of those who do not. Often, as in the case of term life insurance prices, the information existed but in a woefully scattered way. (In such instances, the Internet acts like a gigantic horseshoe magnet waved over an endless sea of haystacks, plucking the needle out of each one.) The Internet has accomplished what even the most fervent consumer advocates usually cannot: it has vastly shrunk the gap between the experts and the public.

  The Internet has proven particularly fruitful for situations in which a face-to-face encounter with an expert might actually exacerbate the problem of asymmetrical information—situations in which an expert uses his informational advantage to make us feel stupid or rushed or cheap or ignoble. Consider a scenario in which your loved one has just died and now the funeral director (who knows that you know next to nothing about his business and are under emotional duress to boot) steers you to the $8,000 mahogany casket. Or consider the automobile dealership: a salesman does his best to obscure the car’s base price under a mountain of add-ons and incentives. Later, however, in the cool-headed calm of your home, you can use the Internet to find out exactly how much the dealer paid the manufacturer for that car. Or you might just log on to www.TributeDirect.com and buy that mahogany casket yourself for only $3,595, delivered overnight. Unless you decide to spend $2,300 for “The Last Hole” (a casket with golf scenes) or “Memories of the Hunt” (featuring big-racked bucks and other prey) or one of the much cheaper models that the funeral director somehow failed even to mention.

  The Internet, powerful as it is, has hardly slain the beast that is information asymmetry. Consider the so-called corporate scandals of the early 2000s. The crimes committed by Enron included hidden partnerships, disguised debt, and the manipulation of energy markets. Henry Blodget of Merrill Lynch and Jack Grubman of Salomon Smith Barney wrote glowing research reports of companies they knew to be junk. Sam Waksal dumped his ImClone stock when he got early word of a damaging report from the Food and Drug Administration; his friend Martha Stewart also dumped her shares, then lied about the reason. WorldCom and Global Crossing fabricated billions of dollars in revenues to pump up their stock prices. One group of mutual fund companies let preferred customers trade at preferred prices, and another group was charged with hiding management fees.

  Though extraordinarily diverse, these crimes all have a common trait: they were sins of information. Most of them involved an expert, or a gang of experts, promoting false information or hiding true information; in each case the experts were trying to keep the information asymmetry as asymmetrical as possible.

  The practitioners of such acts, especially in the realm of high finance, inevitably offer this defense: “Everybody else was doing it.” Which may be largely true. One characteristic of information crimes is that very few of them are detected. Unlike street crimes, they do not leave behind a corpse or a broken window. Unlike a bagel criminal—that is, someone who eats one of Paul Feldman’s bagels but doesn’t pay—an information criminal typically doesn’t have someone like Feldman tallying every nickel. For an information crime to reach the surface, something drastic must happen. When it does, the results tend to be pretty revealing. The perpetrators, after all, weren’t thinking about their private actions being made public. Consider the “Enron tapes,” the secretly recorded conversations of Enron employees that surfaced after the company imploded. During a phone conversation on August 5, 2000, two traders chatted about how a wildfire in California would allow Enron to jack up its electricity prices. “The magical word of the day,” one trader said, “is ‘Burn, Baby, Burn.’” A few months later, a pair of Enron traders named Kevin and Bob talked about how California officials wanted to make Enron refund the profits of its price gouging.

  KEVIN: They’re fucking taking all the money back from you guys? All the money you guys stole from those poor grandmas in California?

  BOB: Yeah, Grandma Millie, man.

  KEVIN: Yeah, now she wants her fucking money back for all the power you jammed right up her ass for fucking $250 a megawatt hour.

  If you were to assume that many experts use their information to your detriment, you’d be right. Experts depend on the fact that you don’t have the information they do. Or that you are so befuddled by the complexity of their operation that you wouldn’t know what to do with the information if you had it. Or that you are so in awe of their expertise that you wouldn’t dare challenge them. If your doctor suggests that you have angioplasty—even though some current research suggests that angioplasty often does little to prevent heart attacks—you aren’t likely to think that the doctor is using his informational advantage to make a few thousand dollars for himself or his buddy. But as David Hillis, an interventional cardiologist at the University of Texas Southwestern Medical Center in Dallas, explained to the New York Times, a doctor may have the same economic incentives as a car salesman or a funeral director or a mutual fund manager: “If you’re an invasive cardiologist and Joe Smith, the local internist, is sending you patients, and if you tell them they don’t need the procedure, pretty soon Joe Smith doesn’t send patients anymore.”

  Armed with information, experts can exert a gigantic, if unspoken, leverage: fear. Fear that your children will find you dead on the bathroom floor of a heart attack if you do not have angioplasty surgery. Fear that a cheap casket will expose your grandmother to a terrible underground fate. Fear that a $25,000 car will crumple like a toy in an accident, whereas a $50,000 car will wrap your loved ones in a cocoon of impregnable steel. The fear created by commercial experts may not quite rival the fear created by terrorists like the Ku Klux Klan, but the principle is the same.

  Consider a transaction that wouldn’t seem, on the surface, to create much fear: selling your house. What’s so scary about that? Aside from the fact that selling a house is typically the largest financial transaction in your life, and that you probably have scant experience in real estate, and that you may have an enormous emotional attachment to your house, there are at least two pressing fears: that you will sell the house for far less than it is worth and that you will not be able to sell it at all.

  In the first case, you fear setting the price too low; in the second, you fear setting it too high. It is the job of your real-estate agent, of course, to find the golden mean. She is the one with all the information: the inventory of similar houses, the recent sales trends, the tremors of the mortgage mar
ket, perhaps even a lead on an interested buyer. You feel fortunate to have such a knowledgeable expert as an ally in this most confounding enterprise.

  Too bad she sees things differently. A real-estate agent may see you not so much as an ally but as a mark. Think back to the study cited at the beginning of this book, which measured the difference between the sale prices of homes that belonged to real-estate agents themselves and the houses they sold for their clients. The study found that an agent keeps her own house on the market an average ten extra days, waiting for a better offer, and sells it for over 3 percent more than your house—or $10,000 on the sale of a $300,000 house. That’s $10,000 going into her pocket that does not go into yours, a nifty profit produced by the abuse of information and a keen understanding of incentives. The problem is that the agent only stands to personally gain an additional $150 by selling your house for $10,000 more, which isn’t much reward for a lot of extra work. So her job is to convince you that a $300,000 offer is in fact a very good offer, even a generous one, and that only a fool would refuse it.

  This can be tricky. The agent does not want to come right out and call you a fool. So she merely implies it—perhaps by telling you about the much bigger, nicer, newer house down the block that has sat unsold for six months. Here is the agent’s main weapon: the conversion of information into fear. Consider this true story, related by John Donohue, a law professor who in 2001 was teaching at Stanford University: “I was just about to buy a house on the Stanford campus,” he recalls, “and the seller’s agent kept telling me what a good deal I was getting because the market was about to zoom. As soon as I signed the purchase contract, he asked me if I would need an agent to sell my previous Stanford house. I told him that I would probably try to sell without an agent, and he replied, ‘John, that might work under normal conditions, but with the market tanking now, you really need the help of a broker.’”

  Within five minutes, a zooming market had tanked. Such are the marvels that can be conjured by an agent in search of the next deal.

  Consider now another true story of a real-estate agent’s information abuse. The tale involves K., a close friend of one of this book’s authors. K. wanted to buy a house that was listed at $469,000. He was prepared to offer $450,000 but he first called the seller’s agent and asked her to name the lowest price that she thought the homeowner might accept. The agent promptly scolded K. “You ought to be ashamed of yourself,” she said. “That is clearly a violation of real-estate ethics.”

  K. apologized. The conversation turned to other, more mundane issues. After ten minutes, as the conversation was ending, the agent told K., “Let me say one last thing. My client is willing to sell this house for a lot less than you might think.”

  Based on this conversation, K. then offered $425,000 for the house instead of the $450,000 he had planned to offer. In the end, the seller accepted $430,000. Thanks to his own agent’s intervention, the seller lost at least $20,000. The agent, meanwhile, only lost $300—a small price to pay to ensure that she would quickly and easily lock up the sale, which netted her a commission of $6,450.

  So a big part of a real-estate agent’s job, it would seem, is to persuade the homeowner to sell for less than he would like while at the same time letting potential buyers know that a house can be bought for less than its listing price. To be sure, there are more subtle means of doing so than coming right out and telling the buyer to bid low. The study of real-estate agents cited above also includes data that reveals how agents convey information through the for-sale ads they write. A phrase like “well maintained,” for instance, is as full of meaning to an agent as “Mr. Ayak” was to a Klansman; it means that a house is old but not quite falling down. A savvy buyer will know this (or find out for himself once he sees the house), but to the sixty-five-year-old retiree who is selling his house, “well maintained” might sound like a compliment, which is just what the agent intends.

  An analysis of the language used in real-estate ads shows that certain words are powerfully correlated with the final sale price of a house. This doesn’t necessarily mean that labeling a house “well maintained” causes it to sell for less than an equivalent house. It does, however, indicate that when a real-estate agent labels a house “well maintained,” she may be subtly encouraging a buyer to bid low.

  Listed below are ten terms commonly used in real-estate ads. Five of them have a strong positive correlation to the ultimate sale price, and five have a strong negative correlation. Guess which are which.

  Ten Common Real-Estate Ad Terms

  Fantastic

  Granite

  Spacious

  State-of-the-Art

  !

  Corian

  Charming

  Maple

  Great Neighborhood

  Gourmet

  A “fantastic” house is surely fantastic enough to warrant a high price, isn’t it? What about a “charming” and “spacious” house in a “great neighborhood!”? No, no, no, and no. Here’s the breakdown:

  Five Terms Correlated to a Higher Sale Price

  Granite

  State-of-the-Art

  Corian

  Maple

  Gourmet

  Five Terms Correlated to a Lower Sale Price

  Fantastic

  Spacious

  !

  Charming

  Great Neighborhood

  Three of the five terms correlated with a higher sale price are physical descriptions of the house itself: granite, Corian, and maple. As information goes, such terms are specific and straightforward—and therefore pretty useful. If you like granite, you might like the house; but even if you don’t, “granite” certainly doesn’t connote a fixer-upper. Nor does “gourmet” or “state-of-the-art,” both of which seem to tell a buyer that a house is, on some level, truly fantastic.

  “Fantastic,” meanwhile, is a dangerously ambiguous adjective, as is “charming.” Both these words seem to be real-estate agent code for a house that doesn’t have many specific attributes worth describing. “Spacious” homes, meanwhile, are often decrepit or impractical. “Great neighborhood” signals a buyer that, well, this house isn’t very nice but others nearby may be. And an exclamation point in a real-estate ad is bad news for sure, a bid to paper over real shortcomings with false enthusiasm.

  If you study the words in ads for a real-estate agent’s own home, meanwhile, you see that she indeed emphasizes descriptive terms (especially “new,” “granite,” “maple,” and “move-in condition”) and avoids empty adjectives (including “wonderful,” “immaculate,” and the telltale “!”). Then she patiently waits for the best buyer to come along. She might tell this buyer about a house nearby that just sold for $25,000 above the asking price, or another house that is currently the subject of a bidding war. She is careful to exercise every advantage of the information asymmetry she enjoys.

  Does this make her a bad person? That’s hard to say, at least hard for us to say. The point here is not that real-estate agents are bad people, but that they simply are people—and people inevitably respond to incentives. The incentives of the real-estate business, as currently configured, plainly encourage some agents to act against the best interests of their customers.

  But like the funeral director and the car salesman and the life-insurance company, the real-estate agent has also seen her advantage eroded by the Internet. After all, anyone selling a home can now get online and gather her own information about sales trends and housing inventory and mortgage rates. The information has been set loose. And recent sales data show the results. Real-estate agents still get a higher price for their own homes than comparable homes owned by their clients, but since the proliferation of real-estate websites, the gap between the two prices has shrunk by a third.

  It would be naïve to suppose that people abuse information only when they are acting as experts or as agents of commerce. After all, agents and experts are people too—which suggests that we are likely to abuse information in our p
ersonal lives as well, whether by withholding true information or editing the information we choose to put forth. A real-estate agent may wink and nod when she lists a “well-maintained” house, but we each have our equivalent hedges.

  Think about how you describe yourself during a job interview versus how you might describe yourself on a first date. (For even more fun, compare that first-date conversation to a conversation with the same person during your tenth year of marriage.) Or think about how you might present yourself if you were going on national television for the first time. What sort of image would you want to project? Perhaps you want to seem clever or kind or good-looking; presumably you don’t want to come off as cruel or bigoted. During the heyday of the Ku Klux Klan, its members took pride in publicly disparaging anybody who wasn’t a conservative white Christian. But public bigotry has since been vastly curtailed. Even subtle displays of bigotry, if they become public, are now costly. Trent Lott, the majority leader of the U.S. Senate, learned this in 2002 after making a toast at a one hundredth birthday party for Strom Thurmond, his fellow senator and fellow southerner. Lott made a reference in his toast to Thurmond’s 1948 campaign for president, which was built on a platform of segregation; Mississippi—Lott’s home state—was one of just four states that Thurmond carried. “We’re proud of it,” Lott told the partygoers. “And if the rest of the country had followed our lead, we wouldn’t have had all these problems over all these years either.” The implication that Lott was a fan of segregation raised enough of a fury that he was forced to quit his Senate leadership post.

  Even if you are a private citizen, you surely wouldn’t want to seem bigoted while appearing in public. Might there be a way to test for discrimination in a public setting?