Undergraduate Economist

Perspectives of an economics student

The Economics of Information-Part 2

Posted by Alex M Thomas on October 7th, 2006

On Information Economics

In ‘The Undercover Economist’, Tim Harford talks about information asymmetries in his third chapter titled ‘The inside story’.

He says that “Economists have known for a while that if one party to a deal has inside information and the other does not, then markets may not work as well as we would hope.” He focuses his study mainly on the American health insurance. This is true for most other exchanges taking place in today’s markets. The stock market runs on ‘inside information’.

Harford goes on to say that “Sellers know whether the car they’re selling is a lemon or a peach. Buyers have to guess.” Likewise, in other markets, sellers are advantaged with inside information.

“The problems of imperfect information include adverse selection (lemons) and moral hazard.” says the book. To make matters worse, the consumer finds it difficult to find out better alternatives.

He emphasises that Akerlof did not describe universal ignorance, but of a situation where one side knows more than the other.

Akerlof pointed to the prevalence and importance of similar information asymmetries, especially in developing economies. One of his illustrative examples of adverse selection is drawn from credit markets in India in the 1960s, where local lenders charged interest rates that were twice as high as the rates in large cities. However, a middleman who borrows money in town and then lends it in the countryside, but does not know the borrowers’ creditworthiness, risks attracting borrowers with poor repayment prospects, thereby becoming liable to heavy losses.

The producer (after being in the market for a sufficient while) knows how much the consumer is willing to pay for the product or service. But the consumer never knows the actual cost of production and nor does he know to what extent the producer is willing to lower the price. Thus, Consumer surplus is known by the producer, but the producer surplus is almost never known to the buyer. The consumer is extolled as the king of the market. Is the consumer really the king?

One Response to “The Economics of Information-Part 2”

  1. peryourrequest Says:

    I would think that both consumer and producer surplus are unknown to the other party. That is why negotiations are important, its each party trying to figure out the other person’s willingness to pay.
    This comes to play in the mortgage business. Loan officers are always trying to figure out how much does a borrower really want/need the loan because their commission becomes dependent on that want.

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