The Need for Information in a Market

The discipline of economics makes use of a plethora of theories and models to explain economic phenomenon. The limitation of these models is that it cannot account for all scenarios and thus there is usually a discrepancy between what is modelled and what occurs. Models make use of many assumptions to allow for economic analyses. One assumption used is the idea of perfect information; there is perfect information between all parties involved in a transaction. The economist Joseph Stiglitz questioned this idea. He believed that there is no perfect information in the market and as a result the lack of information influences the nature of economic equilibrium.

The importance of information and equilibrium can be understood through the insights of George Akerlof. George Akerlof showed how imperfect information affects economic equilibrium with an example of a second-hand cars market. He classified the second-hand cars in two categories; Lemons and Cherries. Lemons were bad quality second-hand cars and Cherries were good quality second-hand cars. The car salesman has good information on cars and could categorise cars as lemons and cherries; furthermore his objective would be to maximise his profits on each car sold. A consumer appears with limited knowledge on cars and wishes to purchase a car. The salesman could take advantage of this and sell a lemon car to the salesman at the price of a cherry making a very high profit. This could lead to a flooding of the car market with lemons, while cherry cars eventually leave the market. This would imply that the second-hand car market would no longer have good cars to sell and could possibly lead to a long run failure of the market with no one purchasing cars anymore.

The credit rationing markets

Another instance where information has an important role for optimal market decisions is in the credit market. Credit rationing is based on the idea that there is a limited supply of credit with a given interest rate. In an optimal market, the forces of supply and demand would fix certain levels of the interest rate that would allow the borrowers and suppliers of credit to craft their demands and meet their project deadlines. However due to a lack of information about the risk probabilities of the borrowers, the interest rate plays a role in assisting banks to mitigate risks by sorting potential borrowers (the adverse selection effect) or affecting the actions of borrowers (the incentive effect). The adverse selection aspect of interest rates is a result of different borrowers having different probabilities of repaying their loan. It is difficult for banks to identify “good borrowers,” from “bad borrowers” and to do so it requires the bank to use a variety of screening devices.

The interest rate at which the expected return to the bank is maximized, is referred to by Stiglitz and Weiss as the “bank-optimal” rate (r*). Traditional analyses argue that, in the presence of an excess demand for loans, unsatisfied borrowers would offer to pay a higher interest rate to the bank, bidding up the interest rate until demand equals supply. But although supply does not equal demand at r*, it is the equilibrium interest rate. The bank would not lend to any individual who offered to pay more than r*. In the bank’s judgment, such a loan is likely to be a worse risk than the average loan at interest rate P*, and the expected return to a loan at an interest rate above r* is actually lower than the expected return to the loans the bank is presently making. As a result, there are no competitive forces which lead to supply being equal to demand, and credit is rationed.

Although in their paper Stiglitz and Weiss have focused on analyzing the existence of excess demand equilibria in credit markets, according to them, imperfect information can lead to excess supply equilibria as well. Thus, increase in interest rates generates credit rationing, whereas a decrease in interest rate may have no effect. These informational mechanisms therefore suggest that monetary policy may have asymmetric effects on the economy.

The insurance market

Imperfect knowledge and information also can play a role in the insurance market. Like in the credit market, asymmetric information presents a fundamental problem in the insurance markets. In the insurance market, it is the insurance policyholders whose risk levels are unknown, as policyholders have heterogeneous preferences and unique risk probabilities. The risk level, which is important information for the contract, is private hidden information and not available to the insurer.

High risk individuals require extensive insurance coverage compared to lower risk individuals and thus high-risk individuals are more expensive for the insurance company. Since the insurance company does not know the risk levels of the policy holders, they provide a menu of combinations of insurance contracts and allow the policy holder to choose the one they deem appropriate. If there was perfect information, the insurance company would know which policy would be most effective for the policy holder. The insurance company, with their various policies, also make efforts to reduce the possibility of adverse selection and moral hazards.

Adverse selection is when the asymmetric information is used as an advantage for one party. For instance, if a car crashes into the back of the other vehicle, the insurance company must pay for the damage caused to the boot of the car as well as reimburse the items damaged inside. Thus, to reduce the problem of adverse selection, the insurance companies try to reduce exposure to large claims by limiting coverage and raising premiums.

Moral hazard is when the behaviour of an individual changes after a transaction is complete. This is a common problem in the insurance market as it is related to the way in which the possessions are viewed by the people. An example is when a consumer buys the phone, they will be quite careful with it because the individual would have to bear the cost of the damages incurred on the phone. However, if they insure their phone, then they will become lazier about looking after it as they know that they will not have to bear the cost of its repair.

Living in a world of imperfect information

Since imperfect information can lead to negative outcomes, it is important to have a way through which one can signal information to other parties. This idea was emphasized by Michael Spence. He presented a model where potential employees send a signal about their ability level to the employer by acquiring education credentials. The informational value of the credential comes from the fact that the employer believes that the credential is positively correlated with having greater ability, and would thus be difficult for low ability employees to obtain. Thus, the credential enables the employer to reliably distinguish low ability workers from high ability workers.

In a perfect information market, there would be no need for signalling. Michael Spence uses educational degrees as a signal of productivity. His thought process can be explained in the following manner. Let us assume that there is complete information between the employer and the employee, and thus the employer would know the productivity levels of the employee without needing his educational credentials. Thus, employees would minimize educational qualification as that would have no effect on their productivity.

However, since there is imperfect information, the education degree acts as a signal of productivity. The idea being that getting educated requires significant resources and effort. A person who puts in the effort in getting that education degree might be more driven and productive than a person who does not. Thus, the employer can assume that the person is not averse to effort and would put in the same effort when working, which would increase his productivity.

Therefore, signalling is the way to go to mitigate information asymmetries. In the second-hand car market signalling can also be used to convey information regarding which car can be a lemon or a cherry. Cherry cars can come with a warrantee and better after sales services than a lemon car. Thus, the consumer would be able to identify the cars and this would not lead to a breakdown of the second-hand car market.

From this we can understand how information plays a role in generating optimal market outcomes. When information exists in abundance and is freely available, we would have desirable situations such as perfect insurance, or the best arrangements for borrowing and credit rationing. There would be no need for signalling as everyone would be aware of each other’s productivity, thus limiting information costs. Negative behaviour like moral hazards and adverse selection would not be prevalent as well. It would thus be an ideal world, just like economic theories profess. Unfortunately, this does not exist in reality and we must make do with the information we have to generate the desired outcomes and hope that our decisions bring in the optimal results.

Picture Courtesy- Towards data science




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