The Economics of Information-Part 1

Information in Markets

Generally, we take information to be a collection of facts from which conclusions may be drawn. If the facts tend to be accurate, then so do our conclusions. In the present market economy, information is more or less incomplete and distorted. The discipline of Economics assists us here.

First we need to define and understand what a market is, and then we need to know about the major players in the market. Market is the institutional framework within which the act of exchange takes place or the institutional milieu which is the context of the relationship of exchange between the parties. [Kurien 1993] A market is said to be efficient or in perfect competition if all the participants are fully informed about the various prices and quantities prevailing in the market. This is said to be laputan or impractical. Producers earn profits (Both normal and super normal) based on the fact that they are more informed than those buying from them. The consumers analyse and speculate, and reach conclusions based on that, thinking that they have made the best choice; where as in reality, it is not so. Most often, complaints are hurled at the firms for cheating the consumers and for being opaque in their dealings. This is known as asymmetrical information or information asymmetry.

An exchange or a transaction in a market, is a kind of zero sum game, where a gain for one participant is always at the expense of another. This is so, if we view the market as a separate entity from that of ours. In reality, the whole economy is like a spider’s web, woven closely together which makes its difficult to separately study them.

The main reasons for the exit and entry of firms is based on asymmetrical information. The feeling of ‘more information’ can attract you to the market as well as make you exit from it.

Information system is a crucial and often conveniently ignored component of a market. According to C T Kurien, the major determinants of a market are location, medium of exchange, institutional framework, intermediaries and the information system. [Kurien 1993]

The 2001 Nobel Prize for economics was awarded for the analyses of markets with asymmetric information. George A. Akerlof noted the ‘Lemon Problem’ in 1970. His popular example is that of a second hand car market, where sellers know whether or not their car is a lemon (i.e. perform badly), but where buyers cannot make that judgement without running the car. Given that buyers can’t tell the quality of the car they are buying, all cars of the same model will end up selling at the same price, regardless of whether they are lemons or not. But the risk of purchasing a lemon will lower the price buyers are prepared to pay for any car and, because second hand prices are low, people with non-lemon cars will be little inclined to put them on the market.

Asymmetric information in markets is further aggravated by the advertisements, as they portray the best in their respective products, by employing the best possible personnel. This not only distorts the true image of the product, but also places the consumer in a difficult position.

This phenomenon is present in all spheres of economic activity.

References:

1) On markets in economic theory and policy-C. T. Kurien

2) If Life Gives You Lemons …-Tim Harford

3) George Akerlof, Nobel Prize lecture video

0 thoughts on “The Economics of Information-Part 1

  1. Voluntary exchange is, by definition, a positive sum game. Why would you participate in an exchange if you don’t gain from it?

    In other terms… the surplus from trade is always positive. How it is divided depends on the elasticities of supply&demand. Information issues can effect the distribution of the gain from trade, but this gain is always positive. Never zero.

    Also, there are plenty of private/market solutions to information-related issues: independent certification of products (ISO standards, etc.), trust built in time, consumer reports, sampling, etc.

    Also, your critique of advertising is unjustified. In the worst case, the customer will only be fooled once. But the point of advertising is not for the consumer to be informed, that’s his business to keep himself informed; the point of advertising is to position suppliers.

    Galbraith raised some of the same issues you do but he was wrong on all counts. All of his predictions, most of them at least, were proven wrong. The US didn’t collapse and now it’s doing very well, price controls have been a failure, etc.

    Markets are more resilient and more performant than you give them credit to be. They are, in fact, the ONLY system that has produced wealth, prosperity and progress over the last 500+ years.

  2. Gabriel M. Says:”…Information issues can effect the distribution of the gain from trade, but this gain is always positive. Never zero”
    Your comment is correct in regards to Trade. However, and I might be wrong, I understood that Alex is discussing the impact of asymmetrical information on prices and markets. I agree with most his analysis and do believe that the market is not at equilibrium when informtation is not equally available to both suppliers and demanders of a product. This in turn will cause Consumer and Producer surplus to adjust towards the entity that has more information.
    Overall this would be a zero gains for the consumer. This can be explained in the example of the lemon. I think we all agree that prices would be lower for a good given asymmetric information. In this case individuals purchasing a good car would have a higher Consumer suprlus. However, individuals purchasing a BAD car, would incur the same price in addition to the repair or replacment cost. Over all the consumer gains would be zero or close to it. The market would experince a positive gain as experinced by the producer.
    Finally, Like you, I believe in the power of markets and its progress in the longrun. Nevertheless, I believe Markets systems can not (should not) be implemented everywhere. It is important to appreciate the power of market systems but also understand their limitations.

  3. Good one man !…I kinda got it this time…especially the overall implications of the ‘lemon problem’ that was a good example.

    As someone pointed out above there is a huge market in the US nowadays for private\public initiatives that bridge this gap between the buyer and the seller. For example, there are databases where all information about an automobile – including traffic tickets,collision etc are stored. you can get the report if you pay a nominal fee – this helps enhance the milieu of the marketplace a lot.

    Again…good one…keep posting :)

  4. Adverse selection – thats what the lemon problem is called, if I remember. Also seen in health insurance premiums.

    Excellent post. Good for me to review my economics ever so often! :)

  5. RE: Gabriel
    Voluntary exchange is, by definition, a positive sum game.”

    Do the ‘have nots’ form a part of this voluntary exchange? Because if they did, it would be obvious that they are losing out. The price they are wiling to pay will be very much less than what ‘the haves’ can pay. In this case, does the consumer earn a surplus?
    For the middle class and the upper class(Based on money income), a voluntary exchange would be a positive sum game; at least the consumers would be satisfied. How many consumers really compares prices of similar goods in the market? How many consumers purchase by seeing the advertisements?
    Markets have been progressive but unfortunately humanity has not been able to catch up with the progress of these ‘markets’.
    Could you please point out the article in which Galbraith talks about asymmetries?

  6. Peryourrequest,
    I believe Markets systems can not (should not) be implemented everywhere. It is important to appreciate the power of market systems but also understand their limitations.”

    Precisely. :)

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