Category: George Akerlof

The Economics of Information-Part 2

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’

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