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Markets and the Information Problem

January 7, 2003

Many of the most interesting issues in economics derive from a lesser-known category of alleged market failure: so-called asymmetric information. The problem of asymmetric information is simple. Different people know different things about economic goods. The seller of a used car knows the condition of that car better than do prospective buyers. George Akerlof won his Nobel prize in economics largely for his analysis of information issues in such secondary markets.

Two particular problems result from informational asymmetries. Asymmetric information results in adverse selection—the process by which the worst trading partners drive out the best before trading takes place. The fact that people with bad cars have the most reason to sell means that used cars sell at a heavy discount. This in turn makes the owners of good cars less likely to want to sell.

After trade takes place, people often have an incentive to change their behavior as a result of having entered into a contract. This ‘moral hazard problem’ affects any type of insurance arrangement, since after having been given any kind of guarantee people then have less incentive to take care in their actions. For example, insured drivers have less reason to drive carefully.

These problems pervade markets. Any time that there is any uncertainty regarding the outcome of a transaction, these uncertainties will change behavior. This is said to result in a less-than-ideal resource allocation. Because some people worry about who wants to trade with them and what they will do after the fact, some inherently worthwhile trades will not take place, and those potential gains from trade will be lost.

Some economists point to these losses as proof that we need intervention in markets. For example, restaurateurs know more about the sanitary conditions of their establishments than do their patrons. Government inspection and regulation in this industry is supposed to allay consumer concerns in these matters. This is alleged to increase the efficiency of such industries by lowering information costs.

Of course, both entrepreneurs and consumers have an incentive to find ways of solving these problems. Warranties, guaranties, and refunds instill confidence in consumers when doubts concerning the outcome of trading exist. These are forms of product insurance whereby consumers get compensated when problems arise with the products they purchase. Of course, the supply of such insurance entails real costs.

When deciding how to deal with these problems, entrepreneurs decide between selling insurance and abiding by the buyer-beware doctrine, where buyers accept greater risk in return for a lower purchase price. Under such an arrangement, buyers will be relatively careful about what they buy. This intensifies entrepreneurial competition over market share by making entrepreneurial reputation all the more important.

In this case consumers will all act as monitors to ferret out bad sellers. Thus entrepreneurs will take special care to preserve market share. This process has costs associated with it. Consumers generally know much about the products they buy anyway. However, comparison shopping does take some time and effort. There is some cost here, and some consumers could free ride off of the efforts of others.

Alternatively, entrepreneurs could simply charge a little extra and offer product insurance in the form of a warranty. With any sort of guarantee consumers will have less incentive  to shop around. The fact that they will get compensation if there is a problem with their products means that competition over market share will be less intense. That is, moral hazard will increase.

Yes, this will reduce the efficiency in any market. However, there is also a benefit. Since sellers must now pay for problems with their product, they have a new reason to be careful about what they produce. In order to minimize ex post warranty payments, they will be more careful about the design and quality of their products.

It is not immediately obvious which arrangement is better. One entails higher monitoring costs on the part of consumers. The other entails greater up-front investment on the part of entrepreneurs. Which method is cheaper? There is no reason to assume that either generally is.

What we do know for sure is that entrepreneurs will seek the lowest cost method because they want to maximize profits. Ultimately, this issue will hinge upon what consumers want to pay for this insurance. At a high enough price, they will bear additional risk concerning the products they buy.

We observe this constantly. Consumers buy subcompact cars knowing that these cars are less safe, so that they can save on the purchase price and the cost of fuel. Similarly, consumers will buy extended warranties on cars for a price.

The safety issue is particularly important because it is often the subject of heated debate over regulation. Instances where injuries and fatalities occur because of problems in automobiles have caused some to advocate greater regulation, and in some cases, calls for criminal sanctions.

It is necessarily the case that people will suffer inconveniences, injuries and even death in the course of using some products. No product is ever 100% safe. People generally know this and are willing to accept some risks, particularly when they can save money in the process. While it is certainly true that government intervention can ameliorate certain problems, it is equally true that these solutions can raise additional problems.

If the government forces private companies to carry out recalls or to pay for product repairs or replacement, consumers can rest easier. Of course, this peace of mind will not be for free. Entrepreneurs will factor these costs into their prices, fewer trades will take place, and resource allocation will shift accordingly.

Is this arrangement best? There is no clear answer to this. Left to the market, entrepreneurs would perform cost-benefit calculations to see whether attaching product insurance, or warranties, to their products is worthwhile. Consumers would make their own judgments and the resulting demand would impute value to these warranties. By weighing the related costs and benefits entrepreneurs would then determine the most efficient method of supplying their goods.

This reasoning is by no means new. As Ludwig von Mises wrote in 1920, profit and loss calculations by entrepreneurs lead to an understanding of how to best satisfy consumer demand. Economic calculation enables entrepreneurs to value capital goods. These valuations lead to an efficient investment in capital goods.

The problems of adverse selection and moral hazard imply trade-offs between different types of contractual arrangements. Just as substitutability of capital requires the calculation of profit and loss, trade-offs in different contractual and organizational arrangements require the weighing of costs and benefits by entrepreneurs. It is also important to remember, as Mises wrote, that economic calculation requires real profit and loss assessments by interested (i.e., property owning and profit seeking) entrepreneurs.

The essential defect in the literature on asymmetric information is that it centers on incentives relating dispersed data regarding products themselves rather than on information on the institutions and procedures that enable us to deal with this dispersion. The notion that we can expect central authorities to correct market imperfections assumes that these authorities can know what procedures work best outside of real world experience. It is experience of this kind, in markets with profit and loss, that reveals data on underlying economic conditions so that we can know how best to deal with these problems.

Rather than indicating a need for government intervention, asymmetries in information make the free operation of markets all the more important. With profit and loss statements as a guide, entrepreneurs will determine the least costly methods of dealing with informational problems. Mandates by the government may make some feel that these problems have been solved, but the absence of real profit and loss calculations, not to mention pressure by interest groups, make economically efficient outcomes via intervention a matter of little more than chance.

Since we cannot know which contractual arrangements will work best in advance of experience in markets, we are best served by markets in dealing with these problems. Abandoning markets means abandoning the means by which we learn what procedures work best. This being the case, it is obvious that these so-called market failures in fact call for the unimpaired workings of the market process.


D.W. MacKenzie is a graduate student in economics at George Mason University. Send him MAIL and see his Mises.org Daily Articles Archive. This article ran in the February 2003 issue of The Free Market.


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