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8.11 Market Failure Caused by Imperfect Information

In the earlier discussion of the perfect competition model, we noted the assumption of perfect information of buyers and sellers. Theoretically, this means that buyers and sellers not only know the full array of prices being charged for goods and services, but they also know the production capabilities of sellers and the utility preferences of buyers. As part of that discussion, we noted that this assumption is not fully satisfied in real markets, yet sellers and buyers may have a reasonably complete understanding of market conditions, particularly within the limits of the types of products and geographic areas in which they normally participate.

Imperfect informationIgnorance or uncertainty about the prices being charged for goods and services or the utility preferences of buyers, or uncertainty about the outcome of events. can be due to ignorance or uncertainty. If the market participant is aware that better information is available, information becomes another need or want. Information may be acquired through an economic transaction and becomes a commodity that is a cost to the buyer or seller. Useful information is available as a market product in forms like books, media broadcasts, and consulting services.

In some cases, uncertainty can be transferred to another party as an economic exchange. Insurance is an example of product where the insurance company assumes the risk of defined uncertain outcomes for a fee.

Still, there remain circumstances where ignorance or risk is of considerable consequence and cannot be addressed by an economic transaction. One such instance is where one party in an economic exchange deliberately exploits the ignorance of another party in the transaction to its own advantage and to the disadvantage of the unknowing party. This type of situation is called a moral hazardA circumstance in which one party in an economic exchange deliberately exploits the ignorance of another party in the transaction to its own advantage and to the disadvantage of the unknowing party.. For example, if an entrepreneur is raising capital from outside investors, he may present a biased view of the prospects of the firm that only includes the good side of the venture to attract the capital, but the outside investors eventually lose their money due to potentially knowable problems that would have discouraged their investment if those problems had been known.

In some cases, the missing information is not technically hidden from the party, but the effective communication of the key information does not occur. For example, a consumer might decide to acquire a credit card from a financial institution and fail to note late payment provisions in the fine print that later become a negative surprise. Whether such communication constitutes proper disclosure or moral hazard is debatable, but the consequences of the bad decision occur nonetheless.

Exchanges with moral hazard create equity and efficiency concerns. If one party is taking advantage of another party’s ignorance, there is an arguable equity issue. However, the inadequate disclosure results in a market failure when the negative consequences to the ignorant party more than offset the gains to the parties that disguise key information. This is an inefficient market because the losing parties could compensate the other party for its gains and still suffer less than they did from the incidence of moral hazard.

Further, the impact of poor information may spread beyond the party that makes a poor decision out of ignorance. As we have seen with the financial transactions in mortgage financing in the first decade of this century, the consequences of moral hazard can be deep and widespread, resulting in a negative externality as well.

Market failures from imperfect information can occur even when there is no intended moral hazard. In Chapter 5 "Economics of Organization", we discussed the concept of adverse selection, where inherent risk from uncertainty about the other party in an exchange causes a buyer or seller to assume a pessimistic outcome as a way of playing it safe and minimizing the consequences of risk. However, a consequence of playing it safe is that parties may decide to avoid agreements that actually could work. For example, a company might consider offering health insurance to individuals. An analysis might indicate that such insurance is feasible based on average incidences of medical claims and willingness of individuals to pay premiums. However, due to the risk that the insurance policies will be most attractive to those who expect to submit high claims, the insurance company may decide to set its premiums a little higher than average to protect itself. The higher premiums may scare away some potential clients who do not expect to receive enough benefits to justify the premium. As a result, the customer base for the policy will tend even more toward those individuals who will make high claims, and the company is likely to respond by charging even higher premiums. Eventually, as the customer base grows smaller and more risky, the insurance company may withdraw the health insurance product entirely.

Much of the regulation to offset problems caused by imperfect information is legal in nature. In cases where there is asymmetric informationSomething that is known to one party but not to another party in a transaction. that is known to one party but not to another party in a transaction, laws can place responsibility on the first party to make sure the other party receives the information in an understandable format. For example, truth-in-lending laws require that those making loans clearly disclose key provisions of the loan, to the degree of requiring the borrower to put initials beside written statements. The Sarbanes-Oxley law, created following the Enron crisis, places requirements on the conduct of corporations and their auditing firms to try to limit the potential for moral hazard.

When one party in an exchange defrauds another party by providing a good or service that is not what was promised, the first party can be fined or sued for its failure to protect against the outcomes to the other party. For example, if a firm sells a defective product that causes harm to the buyer, the firm that either manufactured or sold the item to the buyer could be held liable.

A defective product may be produced and sold because the safety risk is either difficult for the buyer to understand or not anticipated because the buyer is unaware of the potential. Governments may impose safety standards and periodic inspections on producers even though those measures would not have been demanded by the buyer. In extreme cases, the government may direct a seller to stop selling a good or service.

Other regulatory options involve equipping the ignorant party with better information. Government agencies can offer guidance in print or on Internet websites. Public schools may be required to make sure citizens have basic financial skills and understand the risks created by consumption of goods and services to make prudent decisions.

Where adverse selection discourages the operations of markets, regulation may be created to limit the liability to the parties involved. Individuals and businesses may be required to purchase or sell a product like insurance to increase and diversify the pool of exchanges and, in turn, to reduce the risk of adverse selection and make a market operable.