It is now recognized in the field of economics that the assumption of perfect information in economic transactions is completely unrealistic and information remains imperfect (not for every transaction or economic activity). Obtaining information can be costly, and the extent of information asymmetries is affected by firms and individuals (Stiglitz, 2000: 1441).
There are several important factors that lead to market failure. The presence of negative externalities – negative indirect effects of the economic transaction on society that is not accounted for; missing markets, which refers to the situation when, due to misplaced incentives, high transaction costs of information asymmetries (which could also contribute to raising transaction costs) needed markets do not exist. For example the missing market for pollution which is also an example of an externality; the presence of monopoly power and information asymmetries—when one party undertaking the transaction is more informed than the other party (Lipsey and Chrystal, 2007: 277). The latter is one of the main reasons leading to market failure as well represents the focus of our paper.
In a perfect competition, firms set marginal costs equal to price and thus to marginal consumer benefit. In an imperfect market competition asymmetry of information develops from the inability to accurately estimate the trade-off between marginal benefit and marginal costs and the relationship between producers and consumers leading to wrong production and consumption choices. In situations of asymmetric information, the allocation of resources will not be economically efficient because it may affect price, quality and the future of goods. Markets where one party tends to have better information than the other party are such as those for antiques, new and used cars insurance, and lending (Lipsey and Chrystal, 2007: 289). If buyers and sellers can resolve the information asymmetries, they can increase benefits by more than their costs (too much spent on the discussion of information asymmetry, discuss the remedies). Moreover, often it is the case that a third institution is needed to compensate for the lack of information through the creation and enforcement of regulations, monitoring and the settlement of disputes.
This paper argues that in order to attain a more efficient allocation of goods and maximise benefits, an institutional framework is needed. State regulatory institutions should accurately provide information to consumers in order to assess the costs and benefits of their choices which directly affect their utility and marginal benefit; set standards and rules so as to provide market players with correct information regarding quality of goods, work conditions, etc (Begg et al., c2005: 256) (can state do that?, what about the cases of employee-employer, lender-borrower, sharecropper-owner, etc. situations?).
Asymmetry of information could have fatal consequences especially in products that can directly affect the health of buyers. Recognising the failure of free markets, governments intervene to help consumers to precisely judge costs and benefits of their choices and enforce standards which aim at reducing risks or health damages or improve their marginal benefit.
Government regulation can also compensate for the inefficiencies caused by the unequal access to information through setting up rules for firms. One case is the high risk industries where workers are exposed to inappropriate health conditions not favouring their health. The firms might not clearly display the level of danger workers’ health, but state bodies which examine the work conditions are responsible for informing workers of potential risks they might even ban those work practices altogether. The outcome might be higher wages for workers, since their willingness to work will have decreased and the firm will have to compensate for the risk. The efficient allocation of wages and hires in this will be attained at the meeting point between workers’ marginal willingness to work and the firm’s marginal willingness to pay more, reaching the market equilibrium.
The wage will be higher because in the light of the new information workers will be less willing to work at the same wage. The situation could also be seen as the trade-off faced by the firm in deciding whether to upgrade its work practices. While there might have been little incentive to improve working conditions originally, once workers know more about the risk and request higher wages, the firm owner may decide that a one-time investment may be needed to improve safety and—hopefully—to reduce wages. Similarly, state policies could also provide a framework enabling firms to act without fearing fraud. For example, when there is no rule of law, firms are less inclined to undertake business since they have no certainty that the other party will respect a contract.
Another example originates from financial crises, where governor of national bank or the ministry of finance inform citizens that the economy is operating based on incorrect assumptions, those investors and citizens are subject of misinterpretation by media and press of banks under risk of bankruptcy. State officials interfere to offer professional and ethical information in reliance to data from financial state institutions that have made correct estimation of bankrupt banks and firms in stock markets. The result is not behaving according to imperfect information spread by press but instead according to the information obtained from government bodies.
This might reveal that keeping savings in banks would not jeopardise the financial status of clients but instead maximise their profits and save banks from potential bankruptcy (very unclear). Of course the flip side is the extent to which citizens trust the government, which reveals the presence of a significant information asymmetry between the government and its citizens but the level of trust displayed by government is not under focus of this paper.
Another kind of state regulation is based on imposition of standards on firm production. This prevents firms from cost minimizing modes of production that would reduce the quality of products to an extent that would be harmful to consumers. Based on the premise that state aims to protect its citizens, state sets certain criteria and rules concerning the production of goods, its perseverations conditions and ingredients. One example is botulism, which is caused by poor preservation resulting in death (Lipsey and Chrystal, 2007: 289).
Another example includes firms that sell products whose expiry date is not displayed or changed. Some health sector target commissions constantly control products in markets constantly so as to ban goods that can be harmful to individuals (all of these examples are about regulations and setting standards, are there any other means of resolving market failures).
The above mentioned examples represent only a few cases when the information displayed to consumers is imperfect and state regulation is needed to correct imperfections. In this paper we concentrated mainly on the asymmetry between consumers and firms, but a similar case may be made for the interactions between firms and clients, as well as between firms. In cases of market asymmetries, the level of information is not reciprocal and the government’s policy with respect to market should be to encourage competitive practices without harming citizens, by imposing standards and providing correct information to consumers (touch upon on other forms of information asymmetries or market failures that government can affect).
BEGG, D., FISCHER, S. & DORNBUSCH, R. (c2005) Introduction to Welfare Economics. Economics. 8th ed ed. London, McGraw-Hill.
LIPSEY, R. G. & CHRYSTAL, A. K. (2007) Market Failure Ch.13. Economics. 11th ed. Oxford, Oxford University Press.
STIGLITZ, J. E. (2000) The Contributions of the Economics of Information to Twentieth Century Economics The Quarterly Journal of Economics, 115, 1441-1478 (article consists of 38 pages).