What We Don’t Know

For the free market to work it is assumed that everyone knows everything, or at least everything they need to know. However the world is full of things we know nothing about. This is the problem of asymmetric information, where one person knows more than the other. This creates many problems which hamper the operation of the free market and prevent it from reaching the perfect equilibrium.

There is one problem every consumer has before buying a product. That is, they pay money without actually trying the product out and knowing anything about its quality. They are in effect, flying blind. Take the cinema for example; you pay your money without knowing whether the movie is any good. As a result you end up going to a lot of rubbish movies (this summer has been particularly bad). This is also a problem when buying electronics, you have no idea how good quality the product is. Sure this television may be cheap, but will it break quickly or is the picture quality terrible?

There is asymmetric information at work at job interviews. The potential employer has no idea how good a worker you are, so they have to guess. This is an inexact science and quite often they end up hiring the wrong person. The potential employee has an incentive to exaggerate their abilities, to the extent that it is almost expected that people tell gross lies in interviews. There is little way for the employer to check to see if you have done all the things you claim to have. As a result, it is incredibly difficult to reach the most efficient outcome.

People try to compensate for their lack of knowledge by using signals. For example a college degree may not teach you anything useful, but it does signal to employers that you are intelligent and capable of learning. Warranties and quality standards can reassure consumers that the product won’t instantly break down. People try to complete meaningless and useless activities just to use it on their CVs and make it look like they are hard-working and helpful. (For example I took part in the “Buddy System” which helped first years adjust to the new school. It was a waste of time because they didn’t need any help, but it’s still on my CV).

Experience is another signal. Looking for work, I know that the one thing everyone is looking for is experience. Employers look for this not only because they have to train you up less (every new job requires some training up) but because it is a signal. It’s a way of telling employers that you were good enough for someone else to hire you, so you must have something going for you. It shows you are capable of doing a job, any job, and all that comes with that (showing up on time, following orders, completing tasks). Simply not getting fired is a signal to employers that although they know little or nothing about you, you might be able to do their job.

A brand is a signal. For example when buying electronics (an area most people have no clue about) people generally rely on brand names. They reason that as they have no way of testing the quality they can rely on a brand that has a good reputation for quality. Of course, brand has as much to do with advertising as actual quality, so the best brands aren’t always the best products. In this way consumers can purchase inferior products and the market won’t reach the most efficient equilibrium.

People also rely on less efficient and more shallow signals. For example people are judged based on how they look or sound. Beautiful people are more likely to get a job and better pay. People are often judged based on their accent (I find myself doing this subconsciously). Someone with a country accent is presumed to be stupid, someone with a North Dublin or a working class accent is presumed to be a gurrier or a troublemaker, while someone with a South Dublin or a posh accent is presumed to be arrogant.

People try to close the information gap by relying on reviews and the opinions of experts. This is the case with restaurants, movies and electronic goods. The problem is that the opinions of experts are quite different from those of ordinary people. I have given up reading film reviews because they recommend terrible movies while slating some quite good ones. Film reviewers tend to have a far more artsy taste than the average consumer. Likewise, the people who write in electronic magazines are usually technology junkies who can easily understand the complex areas and would use it in much different ways to the average consumer. A person who can programme code would not be the best advisor to someone who has difficulty saving a Word file.

People often turn to their networks. So I don’t know what the best phone is, but a lot of people I know bought a Samsung and liked it so I bought one. People value the opinion of their friends who have experienced the product and can warn us of bad ones. On the down side this can lead to a herd mentality and people buying goods just because everyone else is, rather than because it is the best product. This also takes place in hiring, where employers hire friends and relatives of theirs and their staff. The logic being, well at least I know my friends and I know if they are good people or not. Unfortunately good friends don’t always make the best workers.

It is interesting to view how asymmetric information affects racism. If I grow up in a segregated area and only know white people, I won’t be able to judge how good a worker a black person would be. As a result I may not hire him out of uncertainty and ignorance. Likewise, if I hire friends and relatives of current staff, then the dominant ethnic group will stay dominant and the outsiders will remain outsiders. This is the case in Northern Ireland where the dominance of Protestants has been self-perpetuating as much due to asymmetric information as through discrimination.

Asymmetric information can lead to perverse incentives (lack of knowledge can lead to the wrong things happening). Take doctors and lawyers. You don’t know how good they are until after you hire them. Even still, this is heavily dependent on the specifics of your trial or illness, as well as simple luck. So people try to guess skill and quality based on how much a doctor or lawyer charges, presuming that the person who charges the most is the best and the person who charges the least is the worst. This means that the more a lawyer or doctor charges the better people think they are, so the more money they make. This is part of the reason why trials are so expensive and lawyers are some of the richest people in the country.

It is because of asymmetric information that we have government regulation. If people don’t know about a product then regulation on quality can reassure people that at least it won’t kill them. I am reassured about going into a restaurant knowing that even though I cannot see the kitchen, it isn’t necessary for me to personally test my food for disease. If all pilots have to undergo a government exam in order to fly a plane, then the fact I know nothing about a pilots’ skill doesn’t prevent me from getting on a plane. Regulation ensures that if you put your money in a bank, someone doesn’t simply take the money and run (I’m presuming proper and sufficient regulation).

This is also the case in the workplace. Before accepting a job I have little or no idea of the working conditions. However regulations ensure that I won’t be joining a sweatshop hell-hole run by a slave driver. There are so many ways you can be injured on the job (more people are killed at work than in war) that it is impossible for an individual to calculate the risk and decide if it is worth taking (presuming they’re not a maths genius or someone with enough money they can credibly threat to quit their job). How could any individual know of the threat and risk of asbestos? No person could calculate the risk of working with chemicals, so government regulation ensures proper safety precautions are made.

For the perfect competition dream of free marketers to work it is necessary for everyone to have perfect information. However in the real world, what people don’t know can be a serious impediment towards reaching the most efficient equilibrium. When people have to make decisions about things they don’t fully understand (in other words most decisions) the free market can fail. That’s why we have regulations.

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18 Comments

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18 responses to “What We Don’t Know

  1. Well articulated Nielsen. At least this blog adds to my economics lessons

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  3. GM

    I don’t have the time to write a long comment here, I will make just one or two points.

    I would like to say that I appreciate your intellectual honesty. I can see that you are making a good honest attempt to analyse these issues and it’s commendable.

    I agree with you when it comes to many of the flaws of mainstream economics. The flaw of assuming perfect information is so severe and so obvious that it should have been thrown out long ago.

    The problem as I see it is that you are following through from this realisation to conclusions which simply do not follow, and I think that this is because of other underlying assumptions which you have not yet challenged.

    The first thing we all accept is that perfect equilibrium does not exist. We need to accept furthermore that it can never exist in the natural world of perpetually changing conditions. Neither the government nor the market can create a world of perfect equilibrium.

    A fundamental criticism I have to make of the above article is that it does not acknowledge the vitality and centrality of markets in information. There are individuals and firms whose entire commercial existence is grounded purely in their ability to provide intelligence and analysis. But when you think about it, virtually everybody in the free market is engaged in information-gathering and forecasting to some extent. Good intelligence is an extremely valuably commodity. Information-gathering and forecasting are at the heart of business.

    What it comes down to is that asymmetric information is no argument at all for government intervention into anything. Despite your apparently clear thinking when it comes to matters religious, you still have that habit, so difficult to give up, of ascribing supernatural powers to the State. The State is nothing but a large coercive monopoly filled with human beings who are somewhat similar to everybody else. It can only violently prevent people from doing things that they want to, or force them to do things that they don’t want to do. That’s it. Nothing else. No magic, no supreme wisdom, no power to shape society in whatever way that it wants to. Just force.

    In the real world and in the free market, people rely on reputations, brand names as you mentioned, their own intelligence-gathering capabilities, and the intelligence-gathering services of others to help them make decisions. The market, as I’ve mentioned elsewhere, is a dynamic discovery process. Getting information is itself a vital skill and an essential part of this process. The fact that some people are better at it than others does nothing to justify a coercive monopoly ruling over everybody’s life for allegedly altruistic purposes. There is simply no connection between the fact that information is scarce and unevenly distributed and any requirement for this institution.

    • I agree with your opening paragraphs. However I feel the market doesn’t always get the price right, due in part to asymmetric information. Sometimes market signals become distorted and this is where problems arise and we do not reach an efficient equilibrium. So while many try to find information, many do not succeed.

      I wouldn’t take such a negative view of the state, even if it is not a God. For example, I have no idea about how chicken is made. There is no way for me to monitor how the chicken in my supermarket was made. I have no idea if it is clean or diseased. Even if I could find out, only I would know, other consumers would still be ignorant. The government on the other hand could easily hire an inspector to examine the factory and enforce relatively simple rules and basic hygiene. This could be taken to the next level and a scientist could be hired to test if the chicken is poisonous or not. None of this presumes supernatural powers on the states behalf. Of course it is not perfect as some companies will try to avoid these regulations, but it is better than nothing.

      If there was no regulation and the company was selling poisonous chicken, consumers may never find out. Most diseases don’t kill you instantly, but rather take several years (smoking for example), in which case you may never know what it was that killed you. Even in a shorter time period, you eat so much in one week that you may never know what exactly it was that made you sick.

      The problem with using reputation, brands and advice from friends is that all of them are flawed methods that can be easily biased. Brand is based as much on how much advertising spending a company does as much as quality. Peer pressure can lead to herd mentality and fashion fads. Not an excuse for a “coercive monopoly” but rather some limited regulation.

      • GM

        What I think you’re missing is that the government is itself nothing but an extremely large corporation with monopoly powers. It doesn’t have any great productive ability that could not be provided by some other institution. That is why I accuse you of ascribing supernatural powers to it; you say that it can solve problems by simply doing this or that, when the free market would permit anybody to do those things too.

        To the extent that people want assurances that their food is safe, they can choose to shop only at outlets which have provided those assurances to them. It may be the case that people don’t need as much assurance as you think they do. But in the free market, consumers are free to express their preferences by choosing who to do business with. The government has neither the specific information nor the appropriate incentives to improve upon this framework.

        • The reason why government must provide regulation is because the private sector cannot. There is no private sector regulatory body that enforces regulations across all companies. The problem has to do with incentives. Why would a company pay for a standard that it would fail? Obviously it won’t so it will only pay for regulation that makes it look good. Private sector regulators know this and know their pay is dependent on telling the company what they want to hear. As a result any private sector regulatory body will be very weak to the point of useless, because that is the profit maximising choice.

          So instead some companies have their own standards they make themselves. Of course, if you make the rules, they won’t be critical of you. So a consumer is no wiser because every company has its own standards that give itself a gold star. So individual standards are useless.

          So consumers have to blindly guess. As I discussed in the post, they cannot possible check all their food for disease or their products for defaults. So when you say people can go to a shop that provides assurances that they want, the problem is that unless there is a uniform and independent standard, these assurances are useless. Only the government can provide a universally recognised and accepted measure.

          There is an implicit agreement between companies and private regulators like accountants. You don’t pay someone to criticise you, you pay someone to praise you. Both sides know that if the regulatory group is overly harsh, then it won’t get next years contract. That’s why private accountants never broke any scandal over the last decade.

          • GM

            Do people really want a universally recognised and accepted measure in every industry? In the case of food: If I go to a McDonalds in Dublin or in Tokyo, I don’t need assurances from some global regulator of fast food that it’s safe. I trust McDonalds not to kill me. If I buy food from a street vendor on the side of the street in Bangkok, I know that it might kill me but that’s the chance I’m taking for the sake of enjoying the same cheap food enjoyed by the locals. It would be nice to have an assurance from a professional regulator that the vendor’s food was safe, but enforcing a rule that such an assurance had to be given would be so impractical that it would put nearly all vendors out of business immediately. People are willing to take risks without getting regulatory assurance that something is safe.

            Where services have been regulated and licensed by government bodies, for instance the way that doctors have been regulated by the Irish Medical Council, it has clearly been done in such a way that the incomes of doctors have been maximised and the supply of doctors artificially reduced. The great difference between a government regulator and self-regulation is that the government regulator can dictate to consumers whose services they can and can’t use, whereas a private regulator must actually prove its worth to the people it is trying to protect.

            Because of the ability of government regulators to inihibit competition and to place barriers to entry in the way of new entrants, in many cases, it is powerful industry players who lobby for the creation of regulators in the first place. This has been going on since the guilds of the medieval ages.

            • “It would be nice to have an assurance from a professional regulator that the vendor’s food was safe, but enforcing a rule that such an assurance had to be given would be so impractical that it would put nearly all vendors out of business immediately.”

              Why would it be impractical? Its the basis of current health and safety regulation which hasn’t destroyed capitalism. Why should trying local cuisine and not dying be mutually exclusive? Its hardly unreasonable to propose that people should be able to eat without getting poisoned in the process?

              There are two types of regulation. One that deals with rules (like what I discussed) and the other deals with limiting competition (what you mentioned). I think the second kind is a discussion for another time and shouldn’t be lumped together with the first kind. There is no necessary effect on competition coming from the first kind (other than unsanitary restaurants may be closed). Reducing competition is not its aim or necessarily the end result.

              • GM

                “There is no necessary effect on competition coming from the first kind (other than unsanitary restaurants may be closed).”

                There is always the risk of eating something unhealthy. People don’t have access to all the information they might like. But you are, I might say, “stuck” in the left-liberal paradigm which says that the reason we have access to safe, healthy food is thanks to government regulations. But modern sanitation is something that societies can afford only when they have accumulated sufficient capital and become sufficiently wealthy in the first place. First world sanitation regulations would close down nearly every food supplier in a poor country today, because there simply isn’t the wealth available to provide the arbitrary level of sanitation which you think should be a prerequisite for any food transaction to take place. The same regulations would also have closed down nearly every food supplier in first world countries if these regulations had been applied centuries ago, before we had accumulated the capital necessary to provide modern sanitation. Once we have the capital, then firms can compete on the basis of their sanitation.

                Secondly, I don’t recognise any distinction between rules-based regulations and competition-limiting regulations. It’s not an unusual position, but is an indefensible one, to say that there are rules which can be imposed with effects which don’t distort competition. The example I mentioned was doctors – don’t you think that medical licensing is dressed up as a way of enforcing basic standards, not restricting supply or limiting competition? It is absolutely routine procedure for those who wish to limit competition to say that their objective is merely to improve quality or enforce basic standards. In a corporate industry such as the food industry, it’s the biggest and richest firms who will clamour for blanket regulations to be imposed – they are the ones who will be able to afford to jump through the regulatory hoops, and then they won’t need to worry about the threat of cheaper competition which some consumers might prefer. They will say that their motives are altruistic, but you’ve learned not to believe everything you’re told by now.

        • GM, I am concerned about you first statement here. Because you “think the government is itself nothing but an extremely large corporation with monopoly powers” did not make your thinking correct. the question that will follow that statement naturally is “says who” If you cannot answer that, then, there is no need to waste further time reading your thought.

          • The government has the ability to tax, imprison and in some cases kill you without repercussions. That is not a monopoly? How many companies out there actually directly compete with government services? None. Describe what you believe a corporation is and what monopoly powers are or your refutation holds no relevance.

            • Yes the government has a monopoly on violence, but that does not mean it is the same as a corporation. After all, corporations are not subject to the will of the people. We have no say in how corporations spend the money we give them. The government is essentially a group of people coming together to act collectively, whereas a corporation is an organisation whose aim is to make a profit. Very different.

  4. The problem of asymmetric is a problem not only of a free enterprise system. It also is a problem of democracy. People can’t make intelligent choices if they don’t have access to adequate information.

    Requirements for full disclosure can help. When I buy groceries, I am able to make better decisions because the U.S. Food and Drug Administration requires lists of ingredients in order of amount, so that I know what goes into my can of soup, and unit pricing, so I can compare the price of one brand to another.

    Another thing that helps is availability of expert and impartial information. When I buy a car, I always consult the annual automobile issue of Consumer Reports magazine.

    In many situations, such as telephone service or insurance, I would prefer to have just one choice, if I could be sure that service was adequate, rather than have many choices, without being able to tell which was trying.

    Having to make decisions based on incomplete information is part of the human condition. Within a free-market system, this can be mitigated by requiring transparency, prosecuting fraud and providing expert information from impartial sources.

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  6. Patavina

    To me the most important example of asymmetric information is when we have to elect politicians. We the people do really not have enough information, and furthermore most of what we have is the wrong information.

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