Question

Bond dealers buy and sell bonds at very low spreads (A spread is the difference between the price someone is willing to pay for a good and the price they are willing to sell the good). Used car dealers buy and sell cars at very wide spreads. Recall that the strong form implies prices incorporate private information. What are the potential sources of private information in the bond market versus the used car market? How can these differences explain the differences in the width of the spreads in the two markets?

Answer 1

Spread is the difference between bid (buying) price and ask (selling) price of a good. Information asymmetry is responsible for wider spreads between bid and ask prices of any good. It is the imbalance between negotiating parties in knowledge of factors and details concerning the good in question. consequently, More knowledgeable party has an edge in the negotiation and if other party suspects about this knowledge, spread becomes larger.
Spread in bond market is very low and largely depends on transaction cost. There are usually no hidden or 'private' information relating to a bond. For instance, face value of the bond, its tenure and coupon, everything is a matter of common knowledge. Both buyers and sellers of the bond have same information. There is unlikely to be any 'private' information known to only one party in bond market. Hence, buyers and sellers in bond market are willing to trade at low spreads.
In the market for used cars on the other hand, picture is completely opposite. Here, seller of the used car has virtually entire information about the car and buyer has no information. For instance, seller knows the condition and quality of the car. For example, a seller is likely to know about engine or transmission problems, the maintenance history, and any defective equipment. Seller has all the knowledge about maintainance history, accidents, including speed braking, seatbelt use, airbag deployment, safety and reliability of the car etc. In other words, seller holds all the 'private' information about the car in question while buyer is completely in dark. It is in best interest of the buyer not to believe anything seller tells him. Therefore, buyer considers every used car similar and quotes the price somewhere between what he would pay for high quality car and what he would pay for low quality one. At this bid price, sellers of high quality used car would not agree to sell knowing that their car is more valuable and only low quality ccar sellers will remain in market. This cycle will continue to play as long as such market exist since seller holds the private information regarding the car while there is no reason for the buyer to believe the informatino provided by the seller. Therefore, bid price quoted by the buyer will be far less than price ask ed by the seller.