Information failure

Information failure is another, significant, market failure and can occur in two basic situations. Firstly, information failure exists when some, or all, of the participants in an economic exchange do not have perfect knowledge. Secondly, information failure exists when one participant in an economic exchange knows more than the other, a situation referred to as the problem of asymmetric, or unbalanced, information.

In both cases there is likely to be a misallocation of scarce resources, with consumers paying too much or too little, and firms producing too much or too little. Information failure is common and appears to exist in numerous market exchanges.

It can be argued that markets work best, that is they are at their most efficient, when knowledge is perfect and is evenly shared by all the parties in a transaction. Hence, asymmetric knowledge is an economic problem because one party can exploit their greater knowledge.

There are many examples of information failure associated with economic transactions, including the following cases:

The job applicant, who fails to reveal at a job interview that they do not have a particular skill for the job.
The estate agent, who exploits the fact that a potential buyer of a property has very little knowledge about the property, and any possible problems.
The cigarette manufacturer, who does not inform smokers of the true health risk of smoking.
The buyer of a financial product, who is unaware of the true level of risk, as in the case of derivative products.
The seller of a pension, who misleads purchasers about the financial value of the pension. Indeed, widespread pension ‘miss-selling’ by large UK insurance companies, occurred at the end of the 1990s.

See article on pensions miss-selling

Decision-making bias

Anchoring

Behavioural economists argue that individuals may be subject to anchoring bias when making simple and complex decisions, which acts as a constraint on the exercise of rational choice. Anchors can be visual images or sounds that individuals become focussed on and use to compare options and make decisions. They may create a bias in favour of a particular decision, and perhaps against the best interests of the individual. For example, research by Warwick University discovered that credit card users focussed more on the minimum payment required when looking at their credit card statement than the total sum owed, and this might cause them to run up higher debts that they would do without this ‘low fee’ anchor.

Framing

Individual choices also seem highly sensitive to the process of framing, which also provides a bias in favour of a particular decision. How a choice, or how a new piece of information is ‘framed’ is likely to affect the choice, even when two options have identical outcomes.

For example, numerous experiments have shown that when faced with either winning a given amount of money or losing it, individuals are rather more averse to the loss. For example, individuals are likely to fear a loss, of say £50, rather more than they feel they have gained from being offered £50.

The Lemons Problem

When parties to a transaction are ignorant of certain aspects of the transaction, such as the quality of the product they are buying, they are forced to make assumptions, often based on price. For example, a buyer may assume that goods are of poor quality if their price is low and that goods are of high quality if their price is high.

In some markets, only low quality products will be sold – the so-called lemons problem. The lemons problem was first analysed by American economist George Akerlof in 1970. Akerlof explored the problem associated with pricing second hand cars in the USA, which he called a lemons market – a ‘lemon’ is a derogatory term for a poor quality second-hand car. However, the lemon’s problem has many wider implications in terms of understanding information failure in general.

In the case of motor cars, the sale of a very new second-hand car may make buyers suspicious of the motives of the seller, and wonder whether the car is a ‘lemon’. If an individual buys a new car for £30,000 and tries to sell it on the second-hand market shortly after, they are likely to be forced to accept a much lower price, given the buyer’s suspicions. Not having all the facts, potential buyers are likely to assume the worst and expect the car to have a problem. Given that second hand cars will generally attract a low price, only those sellers who actually have poor quality cars will use this market. After a short period, it can be predicted that all cars sold on the second hand car market will be lemons.

When applying this concept to other markets it can be suggested that, whenever there is information failure, there is the possibility that markets will become lemons markets. If so, the supply of good quality products will fall and the supply of poor quality will products rise.

The principal-agent problem

Asymmetric information is also associated with the principal-agent problem. In an increasingly complex world, individual decision making often relies on the advice given by experts, and a potential principal-agent problem can occur whenever decision makers rely on advice from others with more knowledge than they have. For example, the shareholders of firms, the principals, usually delegate responsibility for day-to-day decision making to appointed managers, the agents. This creates a situation of asymmetric knowledge, with managers knowing much more than the shareholders, and raises the possibility of inefficiencies, especially when shareholders and managers have different objectives.

Examples of these inefficiencies include situations when managers decide to ‘take the easy life’, knowing that shareholders will not find out, and managers deciding to ‘cheat’ and not reveal information to shareholders. This may occur in situations involving insider dealing, where managers can exploit their knowledge of a business’s prospects to buy or sell shares and make a personal gain.

Extra costs

From a firm’s perspective, the principal-agent problem can increase costs, and make the firm less efficient than it could be. These inefficiencies include the costs associated with monitoring the performance of the managers and having to pay a premium to attract the ‘best’ managers.

Moral hazard

Moral hazard, which we saw earlier, is the name given to the negative behaviour that can arise from an individual being insured. When an individual, group, or even an entire economy is insured more risks may be taken than if they are not insured. Moral hazard occurs when people’s behaviour is less careful than it could be, either because they believe that their carelessness will not be found out, or because they are encouraged to behave carelessly. For example, individuals who take out dental insurance may follow a less rigorous oral hygiene regime than those who do not. The term moral hazard was first used in the insurance industry, but it can be applied to many situations.

There are many other examples of information failure, including the following situations:

Consumers may under-estimate the net private and external benefit of merit goods.
Consumers may over-estimate the net private and external cost of demerit goods.
Fishermen may not know the size of fish stocks and, as a result, over-fishing current stocks.

Firms may provide misleading information about products, such as producers of cosmetics claiming to make people beautiful, holiday brochures making resorts appear more attractive, and car drivers not knowing how much pollution they are creating.

Remedies for information failure

Clearly, government has a considerable role in trying to ensure that some of these information failures are reduced or eliminated. The two basic strategies are to increase both the supply of, and demand for, information.

Increasing the supply of information:

Options to increase the supply of knowledge include:

Government may force producers to provide accurate information about products through accurate labelling. For example, requiring that the alcoholic content of drinks is printed on alcoholic drinks, and stating the ‘E’ numbers found in a product – ‘E’ numbers are the European system for indicating chemical additives in food and drink.
Public broadcasts to improve knowledge may also be made, such as informing smokers and drinkers of the true cost of their habit. To help inform the public, a government can subsidise public service TV and radio broadcasting, as in the case of BBC TV and radio.
Laws may be passed to force public limited companies to be more transparent, and publish their financial accounts, as well as have them audited to ensure accuracy.
Government may also regulate advertising standards to make advertising more informative, and less persuasive.
Employers may be forced to request that job applicants disclose information about themselves, such as whether they have a criminal record.
Government may force car owners to have their vehicles regularly checked by a Ministry of Transport (MOT) test, which provides some basic information to potential buyers. All cars over 3 years old must be tested each year, and this gives some assurance to potential buyers that the car is road worthy.
In addition to direct intervention, government may establish organisations to act as regulators and watchdogs, such as the Office of Fair Trading, which tries to ensure that firms compete fairly, and the Competition Commission, which investigates abuse of market dominance by firms with monopoly power. The Advertising Standards Authority (ASA) also promotes ‘ethical’ advertising and regulates the advertising industry in an attempt to improve the accuracy of information available to consumers. The ASA is a self-regulatory body established in 1962, and insists that adverts should be ‘..honest, decent and truthful..’ ‘.. and in line with the principles of fair competition generally accepted in business..’.

Increasing the demand for information

Market theory suggests that demand for knowledge will increase if it is provided freely, or at low cost, hence consumers should not have to pay for information. However, consumers may become overwhelmed with information and fail to take it into account.
Government may also promote the formation of pressure groups such as anti-smoking groups, which campaign for more knowledge to be made available by producers.
In addition, promoting literacy, numeracy, and IT skills may help increase the demand for information. Having the skills to acquire knowledge can create an increase in demand for knowledge, and a greater appreciation of the value of information in making rational choices.

Nudging towards more effective decisions

Behavioural economists argue that small nudges can be used to counteract the effect of misleading or overly complex information.

One problem is that in certain situations individuals may not be able to exert self-control, and select less than healthy choices. For example, food packaging will clearly portray food in its most appealing light, but this may reduce an individual’s self-control when making choices. Hence, although an individual may be over-weight, self-control may not be exerted, and the individual eats an amount larger than is optimal for their immediate health and life expectancy.