Externalities, Public Goods, Imperfect Information, and Social Choice
(Part F)
by
Charles Lamson
Imperfect Information
To make informed choices among goods and services available in the market, households must have full information on product quality, availability, and price. To make sound judgments about what inputs to use, firms must have full information on input availability, quality, and price. The absence of full information can cause households and firms to make mistakes. A voluntary exchange is almost always evidence that both parties benefit. The most voluntary exchanges are efficient. However, in the presence of imperfect information, not all exchanges are efficient. An obvious example is fraud. Frank sells a bottle of colored water to Ed claiming it will grow hair on Ed's bald head. Had Ed known what was really in the bottle, he would not have purchased it.  Adverse Selection: Asymmetric Information The problem of adverse selection can occur when a buyer or seller enters an exchange with another party who has more information. In such a case, there is said to be asymmetric information. Suppose there are only two types of workers: lazy workers and hard workers. Workers know which type they are, but employers cannot tell. If there is only one wage rate, lazy workers will be overpaid relative to their productivity and hard workers will be underpaid. Recall that workers weigh the value of leisure and non-market production against the wage in deciding whether to enter the labor force. Because hard workers will end up underpaid relative to their productivity, fewer hard workers than is optimal will be attracted into the labor force. Similarly, because lazy workers are overpaid relative to their productivity, more of them will be attracted into the labor force than is optimal. Hence, the market has selected among workers adversely.  The classic case of adverse selection is the used car market. Suppose the owners (potential sellers) of used cars have all the information about the real quality of their cars. Suppose further that half of all used cars are "lemons" (bad cars) and that half are "cherries" (good cars), and consumers (potential used car buyers) are willing to pay $6,000 for a cherry but only $2,000 for a lemon. If half the cars for sale were lemons and half were cherries, the market price of a car would be about $4,000, and consumers would have a 50-50 chance of getting a lemon. There is an adverse selection problem because of unequal information: Used-car sellers know whether they have a lemon or a cherry while used car buyers do not. Lemon owners know they are making out like bandits by selling at $4,000, while cherry owners know they are not getting what their car is really worth. Thus, more lemon owners are attracted into selling their cars than are cherry owners. Over time, buyers come to understand that the probability of getting a lemon is greater than the probability of getting a cherry, and the price of used cars drops. This makes matters worse because it provides even less incentive for cherry owners to sell their cars. This process will continue until only lemons are left in the market. Once again, the unequal information leads to an adverse selection. Adverse selection is also a problem in insurance markets. Insurance companies insure people against risks like health problems or accidents. Individuals know more about their own health than anyone else, even with required medical exams. If medical insurance rates are set at the same level for everyone, then medical insurance is a better deal for those who are unhealthy than for those who are healthy and likely never to have a claim. This means more unhealthy people will buy insurance, which forces insurance companies to raise premiums. As with used cars, fewer healthy people and more unhealthy people will end up with insurance. Moral Hazard Another information problem that arises in insurance markets is moral hazard. Often, people enter into contracts in which the result of the contract, at least in part, depends on one of the parties' future behavior. A moral hazard problem arises when one party to a contract passes the cost of its behavior on to the other party to the contract. For example, accident insurance policies are contracts that agree to pay for repairs to your car if it is damaged in an accident. Whether you have an accident or not in part depends on whether you drive cautiously. Similarly, apartment leases may specify that the landlord will perform routine maintenance around the apartment. If you punch the wall every time you get angry, your landlord ultimately pays the repair bill.  Such contracts can lead to inefficient behavior. The problem is like the externality problem in which firms and households have no incentive to consider the full costs of their behavior. If my car is fully insured against theft, why should I lock it? If visits to the dentist are free under my dental insurance plan, why not get my teeth cleaned 6 times a year? Like adverse selection, the moral hazard problem is an information problem. Contracting parties cannot always determine the future behavior of the person with whom they are contracting. If all future behavior could be predicted, contracts could be written to try to eliminate undesirable behavior. Sometimes this is possible. Life insurance companies do not pay off in the case of suicide. Fire insurance companies will not write a policy unless you have smoke detectors. if you cause unreasonable damage to an apartment, your landlord can retain your security deposit. It is impossible to know everything about behavior and intentions. If a contract absolves one party of the consequences of its action, and people act in their own self-interest, the result is inefficient. Market Solutions Imperfect information violates one of the assumptions of perfect competition, but not all information problems are market failures. In fact, information is itself valuable, and there is an incentive for perfectly competitive producers to produce it. As with any other good there is an efficient quantity of information production.  Often, information is produced by consumers and producers themselves. The information-gathering process is called market search. When we go shopping for a "good buy" or for the "right" sweater, we are collecting the information that we need to make an informed choice. Just as products are produced as long as the marginal benefit from additional output exceeds the marginal cost of production, consumers have an incentive to continue searching out information until the expected marginal benefit from an additional hour of search is equal to the cost of that additional hour. After I have looked in 11 different stores that sell sweaters, I know a great deal about the quality and prices available. Continuing to look takes up valuable time and effort that could be used doing other things. In shopping for a house or a car, I may spend much more time and effort searching out information that I might for a sweater, because the potential benefits (or losses) are much greater. The rapid development of the Internet has had an enormous effect on the availability of information to consumers. The Web allows instantaneous comparative shopping for everything from automobiles to airplane tickets to mortgage rates. For some goods, the Internet has effectively "solved" the imperfect information problem, but the Internet itself is not always reliable. The information that consumers take off the Web is only as good as what is put in. Firms also spend time and resources searching for information. Potential employers ask for letters of reference, resumes, and interviews before offering employment. Market research helps firms respond to consumer preferences. It should come as no surprise to you that the general rule is: like consumers, profit-maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs. Many firms produce information for consumers and businesses. Consumer Reports is a magazine that tests consumer products and sells the results in the form of a periodical or through subscription at its Web site consumerreports.org. Credit bureaus keep track of people's credit histories and sell credit reports to firms who need them to evaluate potential credit customers. "Headhunting" firms collect information and search out applicants for jobs.  Because the market handles many information problems efficiently, we do not need to assume perfect information to arrive at an efficient allocation of resources. However, some information problems are not handled well by the market. Government Solutions Information is essentially a public good. If a set of test results on the safety of various products is produced, by having access to that information in no way reduces the value of that information to others. In other words, information is nonrival in consumption. When information is very costly for individuals to collect and disperse, it may be cheaper for government to produce it once for everybody. In many cases, the government has set up special administrative agencies to ensure that accurate information reaches the public. Congress established the Federal Trade Commission (FTC) in 1914 to specifically to deal with unfair and deceptive trade practices. The FTC regulates advertising, sets standards for disclosure of contents, and so forth. The consumer product safety commission sets standards of safety for potentially unsafe products. The Food and Drug Administration regulates the content of foods and drugs permitted on the market. It is illegal to sell a drug that has not been demonstrated to be effective. Many state governments have passed "lemon laws" that grant car buyers certain rights in case they end up with a troublesome car.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 321-324* end |
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