We're said to be living in an information age. Have access to information and you're guaranteed success and richness. At least, that's what the media and many a quick-get-rich seminar seem to promise. You'd say that getting a computer with modem would be all you need. So simple life is not. The modern hype furthermore ignores a very sophisticated information system that has been in place for ages. That is the system of markets.
Go back the image of the two islands of supply and demand. In a well-functioning market buyers do not need to know anything of what is happening on the island of supply while the suppliers do not need to know anything about what is happening on the island of demand. The price signals across the divide are all the information they need. An increasing price tells the suppliers and buyers that there is a disequilibrium in the market. Suppliers will read this as an incentive to increase their quantity supplied, and buyers to decrease their quantity demanded. In short, prices constitute the information system in a market economy.
Concept Check 4: Economists, when asked what their work is worth, will likely to refer to their salary. Why is that?
Markets provide a lot of information for free. How much should the average person value a three-bedroom house on a quarter-acre lot in Northern New Jersey? Look it up in the paper and see what the market price is. Suppose you know nothing about art, nothing at all, but have a lot of money. How much should you value the Picasso? A good place to start is an auction. Look at what a Picasso fetches at an auction and you know how experts value a Picasso. (This method is not foolproof because one Picasso is not like the other and there may be inexperienced bidders who drive the price above the limit that the experts want to pay.)
However, markets can be too efficient in the distribution of information. Information about the chemical formulation of AZT for AIDS, say, may cost the Wellcome Company in England millions of sterling pounds to produce, but after the drug is created (and the patent for it expires) other companies can reproduce the drug and sell it far below the price that the Wellcome Company charged. The information that the drug embodies, has become a public good: the producer of the information (Wellcome Company) cannot prevent people from acquiring it. The solution to this problem is the patent. This grants the Wellcome Company the property right over the information for a period of 17 years. (A copyright gives the property right over a written text for the author's lifetime plus 50 years.) It can use the information for itself, or sell the information to other companies.
A patent represents the property right over a concept or idea for a limited number of years.
A copyright is the right to a text.
However, knowing the price is not all that matters in markets. When markets are imperfect participants may need to know what the others are up to. In the chapter on imperfect competition (chapter 11) you learned how important information is in an oligopolistic market. Airlines very much would like to know what the pricing and routing strategy is for the other airlines in the years ahead so they can set a better strategy. That's why they study each other and their market very carefully.
Information is also a problem for the consumers buying products from oligopolies and monopolistic competitors. One flight is not like any other because the airlines are not all the same. One has better service than the others; another makes better connections; again another has a better mileage program. You need to find out about all the options and that takes time or could be costly.
Concept Check 5: Why is there no information problem in perfectly competitive markets?
A serious information problem occurs in the labor market. When you leave school you probably will need to spend a lot of time and possibly money to find yourself a job. This will be the case even if there're plenty available jobs around. The reason is that jobs differ quite a bit from each other. One boss is better than another. The job may be great but the commute may be terrible. You have to assess the possibilities for advancement. And then we have not even discussed the pay. Labor economists call the costs of finding the right job search-costs. They are part of the transaction costs in the labor market.
Imperfect information can impede the functioning of markets. You can choose the wrong job and employers can hire the wrong people for the job.
Asymmetric information: The lemons problem
The president of a company has superior information on that company compared to the shareholders or the speculators in the stocks of that company. Think how rich she could become exploiting her information advantage, buying stocks a week before she is going public with spectacularly good news and selling them after the news has hit the market floor.
The information is asymmetric when buyers and sellers do not have the same information. That is usually the case in the market for used cars. The sellers have information that you, the potential buyer, do not have: the information is asymmetric. In that case, let the buyer beware. Ask yourself, what kind of car will people be selling? Will they sell their peachy Peugeot that has never given them a day in the garage, has always worked smoothly? No. Those will be kept by whoever owns them. Then what cars will make it to market? The bad Peugeots. Same model, same color, but made on Monday morning, say, when the workers had not quite recovered from a fine Saturday night followed by a very alcoholic Sunday dinner in the high French style. The electrical system gets installed incorrectly, the brakes are missing a certain crucial bolt, the piston was drilled a trifle hastily. The thing is a lemon, doomed to be sold for scrap in its fifth year. Following the same reasoning you would expect that when sellers have an information advantage bad products will drive out the good ones. Economists have been calling this the lemon problem.
Asymmetric information is the case when buyers and sellers do not share the same information.
The lemon problem is the problem that bad products drive out good products from a market due to an information advantage for the sellers.
Concept Check 6: Spot the lemon problem in the selection of students for college.
It's also possible that buyers have more information than the sellers. This happens in particular in the insurance market. When John is prone to light up a cigarette while lying in the bed, he is (if economically rational) more likely to take out fire insurance than Janet who does not smoke and is very careful with fire. Insurance companies-fire and medical-suspect as much, and adjust their rates accordingly. As a consequence-and here's a reason to value the general equilibrium approach-fire insurance can get quite expensive for Janet, the non-smoker, who just wants to cover herself in case someone like neighbor John makes a mistake.
Related is the problem that buyers of insurance may withhold crucial information. It is a replay of the Lemons Problem. Who is most eager to buy life insurance? The man who knows he has a history of heart disease that he has not revealed to the company. What farmer is most eager to buy crop insurance? The one who already had inside information (after all, it is his farm) that his crop will be bad. The problem is called moral hazard, the hazard being that the morality of the insured person might not be good enough for him to level with the insurance company.
Moral hazard is the problem that buyers of insurance may withhold crucial information from the sellers.