Freeman

ARTICLE

What We Know, When We Know it

Information Asymmetries Exist in All Markets

MAY 01, 1997 by LLEWELLYN H. ROCKWELL JR

Llewellyn H. Rockwell, Jr., is president of the Ludwig von Mises Institute in Auburn, Alabama.

To outsiders, mainstream economics can look strange and obscure, or even silly and pointless. The mathematical techniques that dominate most academic journals can be intimidating in themselves. And they are all the more alarming since the subject matter of economics—people who buy, sell, invest, and work—doesn’t seem to lend itself to a wholly mathematical rendering. Physics and chemistry, yes. But economics deals with people and their choices under constraints. Shouldn’t their actions require logical and not mathematical explanations?

Indeed they should, and the best and most influential economists in history have always used words, not equations, to express their ideas. Sadly, the profession took a turn for the worse in the postwar era, and having exalted Keynesian-style policies, hailed measurement and calculus as the essence of all science, even when that science deals with society itself.

In pursuit of this goal, economics became more and more detached from reality and, therefore, from good sense. Economists have dealt with this problem by a professional flight into obscurantism. They began to talk only to each other, because only members of the club could understand and appreciate the peculiar language and the accepted bounds of theorizing. That pattern still dominates.

Sometimes economists emerge from their self-imposed exile from reality to speak about everyday issues. More often than not, however, they do so only for the purpose of criticizing rival schools of thought. (Think of MIT’s Professor Paul Krugman, one of the profession’s leading lights. Most of his popular articles do nothing but bash supply-side economics as silly and unscientific.) H.L. Mencken said modern philosophy consists of one philosopher trying to show that some other philosopher is a jackass, and proving it beyond all doubt. Much the same could be said of economics.

When the Nobel Prize committee awards its economics prize, reporters attempt to sum up the winning insight in plain language. Invariably, the result is so banal and ridiculous that people wonder why such a prize was instituted in the first place. People think: Physicists are solving mysteries of the universe, medical researchers are discovering new cures, writers are entertaining us, but what are economists doing? They are merely confusing us, and for this they get a prize.

Sadly, this was the story again in 1996. James Mirrless of Cambridge University and the late William Vickrey of Columbia University won for their work in information asymmetries. The inevitable public confusion that followed wasn’t the fault of the media, which tried to present their theoretical apparatus fairly. The fault lies with economists, who for decades have held on to a theory of human behavior so absurd that it took little more than the application of good sense to correct it, although much more correction is needed.

Information Asymmetries

What are information asymmetries and what did Mirrless and Vickrey say about them? These economists described, in highly mathematical terms, what happens when participants in a market exchange have different kinds and incomplete levels of information. Company managers know more about the firm’s prospects for future profitability than stockholders do. A person buying insurance knows more about the potential risks than the insurer. The used-car dealer knows more about the quality of the car than the buyer.

According to mainstream economic theory, these information asymmetries are something to fret about, because they produce bumps on the economic road. If you’re a stockholder and you think the managers are holding out on you, you may not buy the stock, even if you are wrong in your assumption. In other cases, asymmetries can cause people to do things they shouldn’t, like buy lemons instead of well-functioning cars.

The 1996 Nobel laureates have explored the issue at great length. For example, they have argued that information asymmetries in the insurance market can lead to moral hazards. An insurer might offer a policy that pays for doctor visits, but he doesn’t know that the policyholder plans to respond to the prospect of free care by eating junk food and becoming a couch potato. This is a strategic response, but it causes other insurers to overcompensate by making premiums higher than they probably should be (in the assessment of economists).

Mirrless and Vickrey also explained that the free market has many ways of responding to the risks posed by information asymmetries. Each party can learn from bitter experience what kind of information he needs to make a profitable exchange.

The stockholder can demand more information about the way a company is run before he buys its stock. An insurer can demand more detailed information about a person before extending coverage. A used-car buyer can develop a more sophisticated understanding of automobile technology, and of the tricks of the trade.

Can Government Fix the Problem?

Yet it’s easy to see why the theory of information asymmetries, even when given a free-market spin, is menacing. If people in the marketplace are flying blind when making such crucial decisions as whether to buy or sell fire insurance, isn’t there a role for government in fixing the problem? That’s the logic that led to lemon laws mandating used-car dealers to guarantee the quality long after the deal is made. Indeed, the information-asymmetry literature has collapsed into yet another variation on the market failure theme composed by economists back in the 1950s.

According to this view, the free market only takes us so far in eliminating differences in the information people have. Interventionists claim, and correctly, that perfect information is hard to achieve through voluntary efforts. So they take the next step: Government should guarantee full information. Thus our economy should be burdened by thousands of requirements that order business to provide full disclosure, even when consumers or stockholders are not particularly interested in getting it.

The warning labels you see on every product from wine to sunglasses are inspired by the view that consumers have no other way of getting necessary knowledge. Every day, we are bombarded with government-mandated information: how much fat is in our food, that so-and-so is an equal opportunity employer, that the terms on a car loan are subject to various constraints, and so on. The idea is to protect the consumer, who the government presumes can’t get the information he needs to make intelligent choices. We hear it all so often, we stop paying attention.

The regulations also presume that business is a vast conspiracy designed to hide information from the buying public, yet the reverse is the case. The whole point of advertising is to bring knowledge that a producer has about his product to the consuming public. What’s more, business undertakes this information-disseminating job at its own expense. Under capitalism, we get most of our information for free, and then decide whether to act on it.

Let’s contrast this with the information confusion inherent in any political race. In the 1996 campaign, the Clinton campaign said that the Dole campaign’s tax plan didn’t add up, a charge which the other side disputed. The dispute couldn’t be resolved because the different camps used different assumptions about how taxpayers will respond to changes in the tax code. Voters had no way of knowing who was right.

With lower taxes, will taxpayers work harder to make more money, or will they choose to purchase more leisure with their higher incomes? Depending on the choice, government revenue can go up or down by tens of billions of dollars. The trouble is that no one knows in advance what people will do. There’s an information asymmetry between the candidates and the taxpayers, i.e., the people who will actually have to live and work under the new tax environment the politicians are proposing.

Now, this may appear to be much ado about nothing, and in many ways, it is. For there are two assumptions behind this information literature that are never proven. First, that all parties affected by an economic exchange need perfect information. Second, that the job of economists is to see that people get it, someway, somehow.

But these assumptions are absurd. The future is always and everywhere uncertain, as every investor or stock trader knows. We can know that certain causes have certain effects (below-market price ceilings cause shortages), but we cannot know with certainty at what time, by how much, or how people will respond to any change in economic life. This is why economists’ qualitative predictions about the future can never be precisely on target.

Ask a mainstream economist why his most recent prediction didn’t pan out, and he will always say: trends changed. That’s precisely the point. Trends are forever changing. However complete and recent statistical information may be, writes Ludwig von Mises, it always remains information about the past and does not assert anything about the future.

The Uncertainty of the Future

In fact, information asymmetries don’t exist in some markets. They exist in all of them. They are built into the very fabric of human life. As Mises said, the uncertainty of the future is already implied in the very notion of action. The future can never be foretold with more than a greater or smaller degree of probability. Oddly, this is a truth that the economics profession has long rejected (or, more accurately, not thought much about) in its futile search for theory analogous to physics.

Neither is government any help. If the market is pervaded by uncertainty and incomplete information, the government is even more so. Officials have virtually no incentive to discover true information, one of many reasons why everything they do brings about sheer waste and inefficiency.

Moreover, there is no reason to think incomplete information is normatively objectionable (yet another hidden assumption in this literature). Let’s look back to St. Thomas Aquinas’s famous example of the desperately thirsty man buying water from a single supplier. The supplier knows that many other suppliers are on their way, but doesn’t reveal this fact so he can command the highest possible price. In St. Thomas’s opinion, the water supplier has no obligation to reveal all his information, though he considers it to be an act of charity if he does.

There are other cases when incomplete information should not be overcome, but rather protected and guarded. In the early sixties, Walt Disney had the dream of building a fabulous Florida theme park encompassing 45 square miles. The trouble he faced was in acquiring the property, which was selling for about $400 an acre. If the existing landowners learned what was afoot, the price of the land would have skyrocketed. Instead, Mr. Disney created 100 corporate fronts, and sent them on a secret land-buying spree.

As Walt Disney knew, there is no moral obligation to reveal all your future intentions unless that is an explicit part of the contract. More to the point, neither party can necessarily know what the future holds. The very existence of the market for stock futures is made possible only because people have different expectations about the future value of the price of the stock. In the never-ending process of market valuations, we are all constantly changing our expectations. The market is a process that constantly adjusts what we know and when we know it.

What Professors Mirrless and Vickrey have done is provide an incomplete corrective to a badly flawed economics paradigm. But more is needed: The paradigm should be overthrown and replaced by a more realistic theory that goes to the heart of what economics should be attempting to do. Economics should not be creating other-worldly mathematical models that have nothing to do with human action, and calling in the state to make the real world conform. Economics should deal with people and their world as they are, alleged imperfections and all.

A minority of the profession is already interested; witness the flowering of the Austrian School, which works in the tradition of Professor Mises’s writings. This tradition rejects the goal of perfect information, and offers a theory that understands how markets can use the uncertainty of the future to the benefit of all, while never invoking the government as a means for achieving the unachievable.

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May 1997

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