Markets with Asymmetric information
What happens when some parties in the market have more info (about a product) than others? The market is an efficient allocator, in a competitive market, when the consumer and producer have perfect information about the possible exchange.
However, it is common to find that to some party in the market has more information (about a product) than the others – asymmetric information. In most cases, the seller of the product knows more about its quality than the buyers does. It also follows that employees know more about their own skills and abilities better than employers.
Asymmetric information explains many of the institutional arrangements in our society. We will look at three situations or arrangements in our society where sellers try avoid some of the problems associated with asymmetric information by giving buyers potential signals about the quality of their products or services.
- It is one reason automobile dealer companies offer warranties on parts service for new cars;
- It is one reason retail stores (on behalf of the manufacturers) offer warranties on parts service for household appliances (fridge, stove or range, washer, dryer, etc.)
- It is why employees sign contrasts that include incentives and rewards.
Asymmetric information about product quality
The implications of asymmetric information about product quality were first analyzed by George Akerlof (1970) in his article, “The Market for the ‘Lemons’” when he used the example of used cars captures the essence of the problem associated with asymmetric information.
According to him, in the market, there are new cars and used cars; and there are good cars and bad cars (known as “lemons” in America) . A new car may be a good car or a lemon, and of course the same is true of used cars. However, it is the owner of the car who knows has more information about it than the prospective buyers. The potential buyer can hire a mechanism to check its quality but still the owner knows more about its several aspects of quality and operations (fuel usage, speed, stability on the road during bad weather, etc.).
It is true to say that used cars, markets for insurance, financial credit, and employment, among others, are characterized by asymmetric information about product quality.
Implications of Asymmetric Information
Asymmetric information is associated with the problem of adverse selection. Adverse selection arises when products of different qualities are sold at a single price because buyers and sellers are not sufficiently informed to determine the true quality at the time of purchase. As a result of this, too much of the low-quality product, and so little of the high-quality product are sold in the marketplace. In some cultures and economies, people have made it an adage that “Quality products are never sold in our market” because they have no true information about the quality of the products in their markets.
Market signaling:
In some markets, to minimize the problems associated with asymmetric information, sellers send buyers signals that convey information about a product’s quality.
This concept of market signaling was first presented by Michael Spence (Spence, M., (1974). Market Signaling. Cambridge , MA: Harvard University Press). In the labour market, the employers may send employees signals about the quality of people they want to hire. For example the employer can state the level of education; and level of experience.
Education level can be measured by several things – number of years of schooling, diplomas or degrees, the reputation of the university or college that awarded the diplomas or degrees, grade of the diplomas or degrees, and so forth. Education can directly or indirectly improve an individual’s productivity by providing skills, information, and general knowledge that will be helpful at work.
We can say therefore that education is a useful signal for the kind of the employees that a company is looking for. It is also a useful signal for productivity because more productive people find much easier to attain higher levels of education. Productive people tend to be more intelligent, more motivated, more disciplined, more energetic and hard-working
Moral Hazard
The possibility that a person’s behaviour may change because they have insurance. In general, moral hazard occurs when one party whose actions are unobserved affects the probability of a payment. For example, when my home is fully insured against theft, I may be less diligent about looking the doors when I leave, and probably chose not to install an alarm system. Why this behavior? Because if the thieves break-in and steal, I will be compensated by the insurance company.
Market Failure
The notion of a market failure might be understood as a case where a market fails to satisfy peoples’ preferences. It is something that is inherent to the market that causes the market equilibrium allocation to be inefficient. Francis Bator (1958), “The Anatomy of Market Failure”, begins as follows:
What is it we mean by “market failure”? Typically, at least in allocation theory, we mean the failure of a more or less idealized system of price-market institutions to sustain “desirable” activities or to stop “undesirable” activities. The desirability of an activity, in turn, is evaluated relative to the solution values of some explicit or implied maximum-welfare problem. (Bator 1958:351)
Why markets fail
- Market power: Inefficiency arises when a producer or supplier of a factor input has market power. Such a producer may decide to supply at lower than the level of efficiency. Such a producer may therefore chooses the output quantity at which marginal revenue, rather than price, is equal to marginal cost and sells less output at a price higher than it would charge in a competitive market.
- Incomplete information: Information is important to the operations of the market – mainly for consumers to make purchase decisions. If consumers do not have accurate information about market prices or product quality, the market system will not operate efficiently for the consumers. Imperfect information or lack of information about the market conditions, prices, and exchanges causes a market failure.
- Externalities: This is a special type of public “goods” or public “bad” whose crucial characteristic is that it is generated and received outside the market. e,.g., Pollution is an externality which a public “bad”.
- Public goods: markets undersupply public goods because of being non-excludable and non-rivalrous – the rider problem. The price mechanism operates well and is an effective allocator of resources under a perfect market. Market imperfections and lack of requisite infrastructure makes the market a poor distributor of goods and services. The market mechanism cannot be relied upon when allocating public goods such as roads, ports, harbors, hospitals, public schools, defense and security.
Externalities
Correcting Market Failure
Pigouvian taxes:
Taxes designed to correct negative externalities are often called Pigouvian taxes because it was Arthur Pigou (1920) who first suggested a tax that would internalize the externality. There are taxes where the polluter pays (such as environmental taxes, or green taxes).
Public policy:
Government or the state provides public goods free of charge (roads, railways, hospitals, ports, harbors, public schools etc.). These public goods would not be provided at all if the state did not provide them. This is a classic example of the role of government in promoting the market economy. Public provision of these services replaces the role of the market. Government can also impose a complete ban on goods deemed harmful to society or to local industries.
