Economics Jun 2, 2015

It Pays to Be Hon­est — Even When You’re Sell­ing Junk

Dis­clos­ing flaws can dri­ve auc­tion bids up.

Based on the research of

Steven Tadelis

Florian Zettelmeyer

How much of the truth should you tell about what you are try­ing to sell?

Check out more from The Trust Project at North­west­ern Uni­ver­si­ty here.

That is a ques­tion faced by any­one who has ever auc­tioned a non-mint-con­di­tion item on eBay or else­where, whether a chair with a stained cush­ion, a vin­tage toy with chipped paint, or a lap­top with a weak bat­tery. Most sell­ers would be tempt­ed to with­hold some or all of the infor­ma­tion about flaws, based on the con­ven­tion­al wis­dom that it would scare off poten­tial buyers.

But what if that wis­dom was wrong?

What if dis­clo­sure of neg­a­tive infor­ma­tion could actu­al­ly boost the like­li­hood of a sale? Flo­ri­an Zettelmey­er, pro­fes­sor of mar­ket­ing at the Kel­logg School, and his col­lab­o­ra­tor Steven Tadelis of Uni­ver­si­ty of Cal­i­for­nia Berke­ley used that line of ques­tion­ing as the basis for a study on auto­mo­bile auc­tions. They found that under cer­tain cir­cum­stances hon­esty on the seller’s part is indeed the best pol­i­cy — even as relat­ed to the sale of a low­er-qual­i­ty item. Specif­i­cal­ly, the researchers showed that an auc­tion house made more sales when it dis­closed more qual­i­ty-relat­ed infor­ma­tion about used cars up for auc­tion, even if that infor­ma­tion was negative.

A Sur­pris­ing Finding

The researchers first set out to exam­ine the mech­a­nisms of auc­tion pric­ing. This is an area with a long his­to­ry in eco­nom­ic the­o­ry. Accord­ing to the link­age prin­ci­ple” first pro­posed by econ­o­mists in 1982, auc­tions in which all known infor­ma­tion about qual­i­ty is dis­closed up front will dri­ve high­er bids on high­er-qual­i­ty items, com­pared with auc­tions in which the qual­i­ty of the item is not dis­closed. Accord­ing to the the­o­ry, this dis­clo­sure process will also depress bids on low­er-qual­i­ty items. But the net ben­e­fit of push­ing bids up on high­er-qual­i­ty items out­weighs the dis­ad­van­tages regard­ing low­er-qual­i­ty items.

It seems like a very bizarre result. You tell peo­ple some­thing that will decrease their val­u­a­tions for a vehi­cle rel­a­tive to a stan­dard, and the next thing that hap­pens is that, on aver­age, you make more money.”

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To test this the­o­ry empir­i­cal­ly, the authors designed a con­trolled exper­i­ment with the help of an auc­tion house with a large busi­ness in used-auto­mo­bile sales. Zettelmey­er and Tadelis took advan­tage of the inten­sive inspec­tion pro­ce­dure through which the busi­ness placed its cars. The researchers ran­dom­ly var­ied the lev­el of infor­ma­tion dis­clo­sure pro­vid­ed in 8,100 auto­mo­bile auc­tions over a 19-week peri­od. Rough­ly half the auc­tions includ­ed qual­i­ta­tive infor­ma­tion from the inspec­tion. For the oth­er half, the auc­tion house knew the inspec­tion results but did not dis­close relat­ed infor­ma­tion to bid­ders as part of the sale process.

The results of the exper­i­ment showed that dis­clos­ing qual­i­ta­tive infor­ma­tion about used cars for sale by auc­tion increased the prob­a­bil­i­ty of a sale — and thus poten­tial rev­enue for the auc­tion house — by an aver­age of 16 per­cent, even when the infor­ma­tion was neg­a­tive. It seems like a very bizarre result,” Zettelmey­er said. You tell peo­ple some­thing that will decrease their val­u­a­tions for a vehi­cle rel­a­tive to a stan­dard, and the next thing that hap­pens is that, on aver­age, you make more money.”

Infor­ma­tion Has a Job” to Do

Zettelmey­er explains this coun­ter­in­tu­itive result with a spe­cif­ic mech­a­nism: the job” the dis­closed infor­ma­tion does for bid­ders. Intu­itive­ly, it seems obvi­ous that a buyer’s goal in obtain­ing qual­i­ta­tive infor­ma­tion about an auc­tion item is to help them eval­u­ate the item objec­tive­ly and bid accord­ing­ly. For exam­ple, the bid­der may see a lap­top with a cracked screen as worth only $50; but the same lap­top with an intact screen might be worth many times that to the same buyer.

But what if the job” of dis­clo­sure is not to help a bid­der eval­u­ate a par­tic­u­lar auc­tion item, but rather to help the buy­er decide in which auc­tion mar­kets to par­tic­i­pate? Zettelmey­er calls this a match­ing mech­a­nism,” and it applies to auc­tions in which many dif­fer­ent items of a sim­i­lar class — like the used cars in this exper­i­ment — are bid upon simul­ta­ne­ous­ly. In this sce­nario, an indi­vid­ual bid­der can­not par­tic­i­pate in all auc­tions at once, and thus must sort through (or match) avail­able options based on the kind of car he or she wish­es to buy.

The dis­closed infor­ma­tion — whether good or bad — acts as a sig­nal bid­ders can use to guide the match­ing process. For exam­ple, a lux­u­ry car deal­er might grav­i­tate to an auc­tion for a light­ly used, late-mod­el BMW sedan. Mean­while, accord­ing to Zettelmey­er, an inner-city deal­er that lives in a low-income neigh­bor­hood more inter­est­ed in buy­ing a car that is in worse con­di­tion.” He con­tin­ued, So the role of infor­ma­tion here isn’t nec­es­sar­i­ly to tell you whether the car is good or bad. Instead, the infor­ma­tion allows you to decide what kind of car you want to bid on in the first place. The dis­clo­sure helps peo­ple select and do what’s most rel­e­vant for them in these situations.”

Find­ing the Right Lane”

The match­ing mech­a­nism dri­ves what Zettelmey­er calls very pro-com­pet­i­tive effects.” Specif­i­cal­ly, the researchers found that the prob­a­bil­i­ty of mak­ing a sale on any item, regard­less of its qual­i­ty, ris­es by an aver­age of 16 per­cent when infor­ma­tion is dis­closed. This hap­pens because the bid­ders self-sort into lanes” where they can com­pete against oth­ers with sim­i­lar buy­ing inter­ests, but only on the auc­tions most rel­e­vant to them. A Mer­cedes deal­er is not going to be able to sell an old Toy­ota Corol­la on his lot, because nobody’s going to be look­ing for a Corol­la on a Mer­cedes dealer’s lot,” Zettle­mey­er said. But deal­ers of used Toy­otas will be hap­py to com­pete against one anoth­er for that same unde­sir­able” vehicle.

Accord­ing to Zettelmey­er, this match­ing mech­a­nism applies to vir­tu­al­ly any online auc­tion” and to many oth­er eco­nom­ic activ­i­ties. The one assump­tion that needs to hold is that you are con­strained in how many items you can bid on,” he says. That means the match­ing mech­a­nism is rel­e­vant to gov­ern­ment pro­cure­ment or job recruit­ment, includ­ing when ven­dors are bid­ding on projects. For exam­ple, if a munic­i­pal­i­ty is seek­ing a con­trac­tor to improve its roads, Zettelmeyer’s find­ings imply that it ought to dis­close sig­nif­i­cant infor­ma­tion not just about the next road con­tract, but also about the road con­tracts planned for the next sev­er­al years.

In this case, the ven­dors sort them­selves into the project-relat­ed lanes that are most rel­e­vant or desir­able for them, just as bid­ders do when faced with mul­ti­ple poten­tial auc­tions to join.

A ven­dor can’t do every road con­tract, so once they bid on one, they will be maxed out for a giv­en time and they can’t do anoth­er one,” Zettelmey­er explains. And so by giv­ing them this view of what’s com­ing up, you allow them to sort them­selves into the con­tracts that they find are the most inter­est­ing for them. And as a result of that, you basi­cal­ly start cre­at­ing groups of bid­ders who are very inter­est­ed in a par­tic­u­lar con­tract and there­by will­ing to put on a par­tic­u­lar­ly cheap price.”

As for auc­tion hous­es, the impli­ca­tions of the research are very clear: greater dis­clo­sure means high­er par­tic­i­pa­tion in auc­tions, which means more rev­enue. Give away inspec­tions — or at least mas­sive­ly sub­si­dize them,” Zettelmey­er says. It looks like you’re doing it out of the good­ness of your heart to keep every­body hon­est and to increase trans­paren­cy in the mar­ket­place. But it also has a direct impact on your bot­tom line.”

About the Writer

John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.

About the Research

Tadelis, Steven and Florian Zettelmeyer, “Information Disclosure as a Matching Mechanism: Theory and Evidence from a Field Experiment.” (2015), American Economic Review, February, Vol. 105 (2), pp. 886-905.

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