Article Written by Zuleykha Gasimova
Economics of Information is a field of microeconomic theory which studies how the imperfect allocation of information affects economic analysis. If we examine the Neoclassical Theory, one of its main assumptions is that everyone has access to the same information (complete information) and everyone has perfect information about the prices of goods and services in the economy (perfect information).
However, as the economic markets developed, availability of more information about goods and services (imperfect information) inspired economists to ask questions about role of information allocation in economic models. In this article, we are going to examine how information is defined in context of economics, and the problems that may arise from imperfect allocation of information between agents.
How is Information Defined in Economic Context?
Complete information refers to an economic situation when information about other market participants is available to all participants.
Perfect information is the term used to indicate that all consumers and producers have access to market prices and know their own utility and cost functions.
Imperfect information (or information asymmetry) happens in situations where one agent or party has access to more or better information than the other. Information asymmetry is the main source of adverse selections and moral hazard because this asymmetry can lead to a power or knowledge imbalance in transactions, where agents do not know their own utility and cost functions.
What Problems Can Be Derived from Information Asymmetries in the Economic Markets?
Adverse selection is a situation where choices of market participants are affected by asymmetric information, which leaves one party who has the access to more information at an advantage. Adverse selection process can lead to a market collapse. One of the most famous classic examples of asymmetric information is “The Market for Lemons” by George Akerlof.
The Market for Lemons
In his paper, George Akerlof illustrated how the information asymmetry between buyers and seller can create market failure. He describes the process by examining the used car market. His hypothesis states that in the used car market there are two types of cars: good used cars (peaches) and bad used cars (lemons). If the buyers do not know the difference between a high-quality car (a peach) and a low-quality car (a lemon) then they are willing to pay the fixed amount for both peaches and lemons (pavg). However, the sellers know if they are selling a peach or a lemon, and therefore will sell at the reasonable price depending on the quality of car they sell. Given the fixed price at which buyers will buy, sellers will sell only when they hold “lemons” (since plemon < pavg) and they will leave the market when they hold “peaches” (since ppeach > pavg), hence leaving only the “lemons” in the market.
Moral hazard in context of information asymmetry means the party who has access to more information decides about risk-taking behavior while the disadvantaged party pays the cost if the situation ends with negative results. An example of this situation might be found in 2008-2009 global financial crisis, when lending institutions were willing to initiate risky lending behavior knowing that they are too important for the economy, and government will provide a financial bailout had things gone wrong.
After a close examination of possible problems that may be caused by information asymmetry, we now understand the importance of information economics. Adverse selection and moral hazard problems can cause failures in political, economic and business environments. Therefore, both private and public sectors are changing their traditional approach of how markets work, allowing to account for more real-world complications such as information asymmetry.