Information Asymmetry in Cross-Border Sales
An Economic Examination
– Summary –
Leipzig, September 2018,
edited in Mai 2020
Cross-border sales volume is less than expected
There are still puzzles in international trade that have yet not been fully understood. For instance, why is cross-border sales volume smaller than trade theories predicted? Why is the volume of trade, especially among poorer and richer countries, less than predicted by the Heckscher-Ohlin-Vanek model?
Consumers have a strong preference for domestic products.
In addition to that, it is also not understood why consumers have such a strong preference for domestic products. Moreover, natural trade barriers (which are not caused by government measures) are still poorly understood even though they have a significant effect.
This paper examines whether the international market could partly fail due to asymmetric information in international trade. If so, the problem of asymmetric (or imperfect) information between potential customers (consumers or companies who are in demand for a product or service) and vendors (supplier who offer or would — under perfect market conditions — offer products or services) could partly contribute to these international trade puzzles.
In contrast to the country of origin effect (which can be negative or positive), information asymmetry in cross-border sales focuses on the problem in the process of cross-border trade. Meaning that the perception of where a product comes from (is produced) is not relevant but where the vendor comes from is.
What are information asymmetries?
At economic theory, we learn the principle of demand and supply and how the market works under perfect circumstances. In practice, however, the market does not have perfect circumstances, and its function can fail. One condition for the perfect market circumstances is that all market participants have complete information for free. Obviously, this is rarely the case. Due to the lack of information, the market is not working as perfectly as if it would in perfect condition, and the market can even fail. This issue is called information asymmetry. There is an asymmetry of information because one side (e.g., vendor) knows more about themselves (e.g., their product quality and their trustworthiness) than the other side (e.g., customer) knows about the first side.
Akerlof's famous "market for lemons"
There are two categories of information asymmetry. One is well explained by Akerlof's famous "market for lemon" paper. He explains that on the second-hand car market, the car dealer (expert) knows more about the car than the consumer (layman) does. The consumer cannot assess whether it is a good car or a bad car (lemon). The consumer can only assume a vehicle is of average quality (if he or she does not see anything obvious) and that the value of the car is average.
Let's assume, there are only two car categories on the market, bad cars with 5,000 EUR value and good cars with 10,000 EUR value, and there would be the same quantity of both types. The consumer could not segregate between which car is good and which bad. He would assess the value of the cars as average with 7,500 EUR value. Now, if one dealer offers a bad car for 7,500 EUR and another dealer offers a good car for 10,000 EUR, the consumer would buy the bad car. The good cars will eventually not be offered anymore. The trade of good cars, which would be beneficial for both sides, does not take place any more. That phenomenon is called adverse selection.
The other category of information asymmetry is moral hazard. Moral hazard means, as the name implies, a social threat. It refers to the behavior of one side at the cost of the other party. A typical example is the insurance industry. The insured person does not care about the insured object as he would if any damage would be at his expense.
Six supportive economic findings
In the search for the state of research of information asymmetry between potential customers and vendors in cross-border sales, it transpired that this topic has not been researched thoroughly in the economic field. Economic research papers that explicitly examine this topic are relatively rare (or at least only relatively few are available to the author). However, some existing theories and researches suggest the existence of the problem of information asymmetry in cross-border sales.
1. Quality label increases international sales
Potoski and Prakash found out that applying the quality management system ISO 9000 increases cross-border sales. That is due to the signaling function of assuring potential buyers a certain level of quality.
2. Buyers discriminate foreign vendors
The theory of liability of foreignness says that foreign companies that operate in another country have a competitive disadvantage over local firms. This disadvantage has several reasons. The main reasons are higher communication costs, lack of knowledge about foreign culture and law, and discrimination by the foreign country's administration. But part of the liability of foreignness is also discrimination from customers against foreign firms. However, this aspect has been (compared to other economic topics) neglected by scholars as relatively few papers focusing on discrimination from customers against foreign firms are publicly available. A significant part of the discrimination is that customers are skeptical about foreign firms. Moreover,buyers prefer domestic products over foreign products, which puts foreign firms at a worse position.
3. A high share of international sales goes through intermediaries and platforms
The share of intermediaries in international trade is quite significant. Blum et al. quantify the percentage of intermediaries in the imports of a country to 25 to 45 percent for each country. This remarkably high share of intermediaries in cross-border sales can be explained by the better ability of intermediaries to screen and signal (the two market solutions of information asymmetry). Intermediaries enable a solution to information asymmetry by offering better signal and screening abilities. That foreign vendors sell to that extent through intermediaries in international trade suggests information asymmetry in cross-border sales. Moreover, Coad and Dach-Brown found out that firms that are using platforms (third solution: independent third parties) for intra-EU cross-border e-commerce experience fewer information barriers. This finding also suggests an existing trade obstacle in cross-border sales caused by information asymmetry.
4. Cross-border information flows have a positive effect on the cross-border trade flows
Cross-border information flows have a positive effect on the cross-border trade flows, which supports the hypothesis of information asymmetry in cross-border sales. Porter and Rey accidentally found out about the correlation between cross-border information flow and cross-border trade flow while examining another topic. For the two scholars, the finding indicates an underestimation of the aspect of information asymmetry in international trade.
5. Companies lack information about foreign countries,
could consumers lack information about foreign companies, too?
Companies (who are generally better informed than consumers) lack information about foreign cultures and systems (Uppsala model) as well as about the market circumstances in other countries (information friction). Thus, a logical conclusion is that consumers must also lack information about foreign companies (and companies about foreign consumers).
The theory of liability of foreignness includes that foreign firms have costs to get informed about the foreign market they want to expand to. The so-called Uppsala model, which explains the internationalization of businesses as a learning process, explains that companies perceive business activities in foreign countries with risks as they do not know enough about the other country. Moreover, theories in international management also take into account the differences in language and culture as well as the differences in the systems of economy, education, and law. Meaning the more different (or so-called psychic distant), the less the company knows about the other country (or the more difficult it is to learn).
In recent years a new topic in economics has come up, which gained the interest of more and more academics: the theory of information friction. Information friction basically means that companies lack information about foreign markets. However, it does not refer to the information asymmetry between vendors and foreign buyers. Instead, according to the theory, domestic and foreign companies have asymmetric information about the domestic market.
Moreover, the same argumentation can be made with asymmetric information between governments and firms in international trade.
6. Immigrants increase bilateral trade flows
Another indication lies in the trade creation of immigrants. Immigrants create additional trade between the country of origin and the country of destination. Head and Ries found out that ten percent more immigrants from one country of origin cause three percent more import from this country and one percent more export to this country. That the cross-border sales from the country of origin of the immigrants to the county of destination are significantly higher than the opposite trade flow might suggest an existing problem of information asymmetries in cross-border sales, which is solved by gaining information about the other country through the immigrants. The increased sales from the country of origin might be caused by enhanced information of the people in the country of destination about the people of the county of origin due to social contact and connection with the immigrants.
Why is information asymmetry an obstacle for cross-border sales?
People know less about people in other countries and their cultures and behaviors. Therefore, consumers can assess foreign vendors not as good and accurate as they can assess their compatriots.
Potential customers know less about the trustworthiness of the business, the products, and the aspects of the products when offered by a foreign vendor. For example, potential customers do not know how safe a product is and more importantly how honest the foreign vendor is about the safety of the product since they do not know as much about the foreign culture as they know about their native culture.
Potential customers (especially consumers and small businesses) perceive a higher risk at the process of the trade itself if the trading partner is in another less familiar country. As a result, the lack of knowledge, about the other culture and unknown behavior patterns ultimately leads to a business obstacle. The potential customers cannot determine whether the foreign vendor is good (trustworthy) or bad (not trustworthy), just as with the lemon theory from Akerlof. Moreover, the difference in the standard of living might provoke the concern of consumers in wealthier countries that vendors in poorer countries could try to scam them (that they try to get money desperately).
German potential customers do not trust Eastern European vendors
Unfortunately, Germans still have a negative bias towards Central and Eastern European countries, and Central and Eastern Europeans are facing economical discrimination in Germany. Consequently, the problem of information asymmetry in cross-border sales could be a real business obstacle for Central and Eastern European businesses selling to Germany.
Vendors cannot assess the creditworthiness of foreign customers
The same argumentation chain applies the other way around, and the vendor's risk is also higher at cross-border trade since the vendor cannot assess the foreign customers' creditworthiness accurately. Furthermore, social control is lesser or even not existing, considering the given geographic and social distance.
But who gives the money or product first?
Consequently, we have a situation where the consumer does not trust the vendor and where the vendor does not know whether the consumer is able to and also intends to pay. But in cross-border sales, inevitably, both sides of the deal cannot be exchanged simultaneously. Hence, one party must give his product or money before the other party fulfills his side of the agreement. But who? That is the problem.
Market solutions do not work as well
Screening and signaling, the market solutions for asymmetric information do not work as well as they do nationally. This is not only due to the larger geographic distance and the language barrier but also to the lack of knowledge on how to understand signals and the lack of received credibility. Larger firms, however, have the means and the interest to screen effectively in spite of the extra costs, that is why the extent of the problem of asymmetric information in cross-border trade is lesser when larger companies are in demand of essential (long-term) supply. Another issue is the different legal systems, which makes it harder to enforce a rightful claim of one party.
If information asymmetry in cross border sales exists will be examined with an empiric method. The structure of production and the structure of export (of produced goods) of the countries of the EU and EFTA will be compared. The difference between the structure of production and the structure of export of each country will be compared between the countries. This comparison aims to see whether a structural difference among the countries is observable. The data are from 2015, the latest year with fully available data at the time this paper was written will be examined. By examine intra-EU trade, trade barriers such as tariffs are excluded.
The structures are formed by the degree of technology. The higher the degree of technology, the higher the value of the products. With higher value comes higher risk which means the problem of information asymmetry to sell high-tech products to potential customers in other countries is greater than to sell low-tech products. Moreover, a higher degree of technology consists of higher knowledge. Consequently, it might be more difficult for potential customers to understand all the aspects of the goods entirely. Hence the importance of trustworthiness of the vendor is greater at high-tech products than at low-tech products. Due to both aspects, the problem of information asymmetry must be more significant in high-tech products than in low-tech products.
The hypothesis says that the evaluation of foreign goods and services, as well as of foreign vendors and potential customers, is less accurate. This assumable leads to an average assessment from the consumers according to the (subjective) reputation of the other, supplying country. The idea for the examination is to use the reputation of one country in the rest of the world to compare the countries' production and export structure according to the countries' perceived image in other countries, and thereby to examine whether countries with a bad reputation have a more significant problem of information asymmetry than countries with a good reputation do.
For the determination of the reputation of the countries in the rest of the world, the most adequate available study Country RepTrack 2015 will be used. Unfortunately, not all examined countries were part of the reputation study. However, this was the study that included the most countries. Moreover, some countries did not provide sufficient enough data due to confidential reasons. That is why only selected countries could be examined.
The results show that countries with a good reputation (score above 65) can increase the share of high-tech at the production to a significantly higher percentage of high-tech at the export (see figure 1). Whereas countries with a bad reputation (score below 65) do have a similar share of high-tech at the production structure, but they can only raise the share of high-tech at the export structure in comparison to the production structure by a little bid (see figure 1).
Figure 1: Comparison of the countries with the good reputation (left) and the countries with the bad reputation (right)
Countries with good reputation: Norway, Austria, United Kingdom, Germany, Spain
Countries with bad reputation: Romania, Czech Republic, Poland, Portugal
Italic: data are not completely available (confidential)
Source: own examination; data from Eurostat (2018a) Eurostat (2018b)
The worse the reputation of one country in the rest of the world is, the more difficult it is for that county to sell its produced high-tech goods to the rest of the world, compared to produced low-tech products (see figure 2). The results indicate the existence of the obstacle of information asymmetry between potential customers and suppliers in cross-border sales, although with limitation as many factors have not been considered. More research is necessary.
Figure 2: Increase or decrease from the share at production to the share at export in percent
Quartile 1: Norway, Austria, United Kingdom, Germany
Quartile 2: Spain, Portugal
Quartile 3: Poland, Czech Republic
Quartile 4: Romania
Source: own examination; data from Eurostat (2018a) Eurostat (2018b)
What about services?
Services have not been included in the empirical examination because services are not well classified in the degrees of technologies nor any other usable classifications. Furthermore, the available data for the production and export of services are less suitable for this examination. That is why information asymmetry in cross-border sales of services is discussed in this paragraph.
Information asymmetry in cross-border sales could have a greater impact on the trade of services than on the trade of products, which could be due to the characteristics of services. For instance, services can hardly be evaluated before the purchase, which increases the problem of information asymmetry. Moreover, the foreign potential customers find it more difficult to understand reviews in the foreign country due to cultural differences and the language barrier. Another characteristic of services is that services are made by internal and external factors, meaning that the customer participates in the production of the service, which also increases the problem of information asymmetry due to the cultural distance and language barrier.
German consumer protection organizations are strictly warning German consumers to go to Central and Eastern European dentists.
One example of that is the market of Central and Eastern European dentist services for German patients. Even though the dentist services must be of comparable quality. German consumer protection organizations are strictly warning German consumers to get treated by Central and Eastern European dentists, which is likely to be a consequence of adverse selection as German patients cannot distinguish between trustworthy and not trustworthy Central and Eastern European dentists. Extensive empiric research for this example and the extent of information asymmetries in cross-border sales of services is necessary.
The international market could partially fail.
Information asymmetry in cross-border sales might antagonize the perfect international allocation of production. It could be possible that one country has a comparative advantage in producing a product and companies produce it relatively efficiently, but that the potential customers in the rest of the world do not trust the vendors of this country and buy less of the product than they would with complete information. The international market could partially fail.
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