EBF 200
Introduction to Energy and Earth Sciences Economics


Information Market Failure


Required Reading

Please read pages 103-106 in Chapter 5, the segments entitled "Potential information Problems" and "Information as a Profit Opportunity." This is in the chapter entitled "Difficult Cases for the market, and the Role of Government."

Perfect information is one of our assumptions of perfectly competitive markets, and it is easy to see that this assumption is perhaps the toughest one to make, simply because perfection is something that does not exist. Information can have many aspects in a market setting. The foundation for our analysis of demand in markets is the idea that people are able to place value on the consumption of goods, on understanding the amount of happiness they will obtain from the economic decisions they make. Since the realization of many of our economic decisions takes place in the future, and because the future has an unknown component, it is basically impossible for us to have perfect knowledge without perfect foresight – and that is something we do not have, and cannot have.

However, as a market failure, this is not something we can correct. We can, as individuals, educate ourselves about the world and what sort of outcomes we can come to expect. We can gain wisdom and insight, but we can never tell the future with certainty. Thus, we will consider this issue further. It is merely a manifestation of the nature of our existence and the linear nature of time.

Instead, we need to concern ourselves with information that is knowable, but the lack of knowledge by one or another party in an economic transaction causes a loss of wealth to society.

Some markets have close to perfect knowledge of present information. Perhaps the best example is the market for shares of widely traded public companies at places like the New York or London stock exchanges. The shares are all homogeneous – one share is exactly the same as another, the prices are readily available, in real-time, to anybody who is interested, and there are many, many people studying the activity of the companies that are being traded. Because they are publicly traded on stock exchanges, these companies are required to release a lot of information to the public about their business activities, their profitability, their debt levels, and so on. Generally, a person buying a share in a large public company like IBM or General Electric or Exxon knows or, at least, has the ability to know, about as much as anybody else in the market for the share in question.

There is one situation where somebody might know something about a company that the general, investing public does not: when a person is an “insider,” and has some non-public knowledge about the future of the company. A manager or director of the company may know that they are in the process of planning a takeover of another company, or are being taken over, or are about to suffer a large loss due to some non-public event. The announcement of such pieces of information can have significant effects on the price of shares of these companies. Thus, insiders can profit greatly by buying or selling stock using information that is not available to the general public. This is what is referred to as an “information asymmetry.” For this reason, insider trading of stocks is highly regulated in many countries. Insiders – managers and directors – have to make public record of their stock trades, and if a material event happens that they can reasonably be expected to have had inside information on, the securities authorities will examine the history of their trades to make sure that they did not profit from that knowledge unfairly. If they are found to have done so, they can be severely punished. In other countries, for example, Germany, the securities authorities make sure that all insider trades are publicized immediately, so that the general public can mimic them. The authorities in countries like this assume that this is a better way to disseminate information about what is going on in markets and in industry. If insiders are making big moves, and people can see them, the market will assimilate that information quicker than it otherwise would. At least, that’s the theory. If you go ahead and study finance, this is what is called the strong form of the efficient markets hypothesis, about which there is a great amount of disagreement in academic and professional circles.

The last type of information market failure concerns another type of information asymmetries: that about products or services being sold. It is not hard to realize that, typically, a seller of a product knows a great deal more about that product than the buyer. Sometimes, a seller will use this to his advantage by not telling the buyer something meaningful and important about the product. This is sometimes referred to as getting “ripped off.”

When will a seller take advantage of such a situation and “rip off” a consumer? The short answer is: when it pays to do so. More specifically, there are some conditions:

  1. When you can’t find out that you are being cheated until after the purchase is made, and
  2. When you can’t punish them once they’ve cheated you:
    • When you only make a single purchase from the seller. For example, most people only purchase a house a few times in a lifetime and very rarely more than once from the same seller.
    • When there is only one seller. If you feel like you’re getting ripped off by the power company or the only gas station for 20 miles, you cannot easily take your business elsewhere.
    • When getting cheated is a small enough loss to not change your preferences.
    • When you will never find out if you have been cheated. One example of this is people undergoing unnecessary surgery. This why they say you should always get a second opinion.

So, summing up, sellers will have an incentive to cheat buyers when buyers cannot adequately punish sellers.

Consumers can also take advantage of suppliers — moral hazard. The best example of this is insurance:

  • a) Insurance companies agree to pay your damages after an accident.
  • b) However, they do not control your behavior, and you have incentives to be risk-loving, knowing your damages will be paid.

Another example is academic integrity:

  • a) Most teachers believe that you hand in your own work and don’t go to great lengths to certify that what you hand in is yours.
  • b) However, they cannot control (or costlessly discover) whether you have done the work yourself, or copied from a friend.

Of course, when insurance companies (or teachers) catch you, consequences are usually significant.

Correcting Information Market Failure

In this case, there are private as well as public (governmental) solutions:

  1. Trade Organizations: If a company misbehaves, their reputation will be hurt and the trade organization will cease to support them.
  2. Consumer Organizations: Publications like Consumer Reports independently monitor companies’ performance and keep consumers informed.
  3. Anti-Fraud Legislation: If you can prove a company cheated you, they will have to pay restitution to you and prohibitive damages to the government.