Information Failure

Information Failure is a situation in which some participants in a market have better information about market conditions than others. Information required by a consumer is the price of the product and qualitative information on the product. Information required by a producer is feedback on the product and the consumer’s reaction to a potential price change.

Asymmetric Information is when either the buyer or seller knows more about the good or service than the other, and the other doesn’t know how trustworthy or how good the quality is of the product and so finds it hard to put a price on the product.

Symmetric Information is the opposite and both parties in a trade know everything about the product (or at least as much as each other, so they could both know nothing but the keyword here is both).

Information failure is responsible for the under-consumption of a merit good, because consumers may not be aware of the benefits to society from consumption. Conversely information failure is responsible for the over-consumption of demerit goods as consumers may be unaware quite how harmful goods such as cigarettes are to society and to themselves. 

This means that consumers may not purchase certain goods that are good for them because they are unaware of the potential benefits to themselves and to society a merit good may possess. This doesn't necessarily mean that they aren't being told by sellers the benefits of the product but it may be because they don't trust the seller. For example there may be a toothpaste brand that is really good for ones teeth, and they advertise that they are the best toothpaste brand in the world (which they are, but the consumers don't know this). This is something that most consumers will have heard time and time again and so they may not purchase the product, thinking that it is just an advertising ploy. This will mean the toothpaste is under-consumed due to information failure (the consumers not knowing how good the product is).

Therefore we can say that asymmetric information has the potential to limit exchange in a market. Depending on the size of the asymmetric information gap markets may collapse or not exist altogether. George Akerlof, a Nobel-prize winning economist, showed this with his paper on "The Market for Lemons". 

The Market for Lemons

A lemon is a term for a low-standard car. Akerlof found that the used car market only sold cars that were lemons. Akerlof then went on to explain that the reason for these poor quality vehicles dominating the second hand car market was due to asymmetric information which limits the quality of cars on sale. 

The reason for this is that sellers that had a high quality car that they wanted to sell would charge more to reflect the quality. Lets say they want to sell it for £30k, medium-quality cars sell for £20k and low-quality cars sell for £10k. Sellers of high-quality cars (remember the seller knows how good the quality is as they have owned the car for x amount of time) therefore want to sell it for £30k. However the buyer doesn't know that the car is of good quality. The seller may tell him it is, but the buyer doesn't have any sure way method of telling that it is. Obviously he could hire an independent impartial mechanic to do a check on the car but this doesn't always find all the errors with the car, it can be expensive and if the buyer were doing this for every car he is interested in then he may well have spent enough money to buy the car! So, since the buyer doesn't know that the car is of high-quality he is cautious to spend £30k on a car. 

In our market, of high, medium and low quality cars priced at £30k, £20k and £10k respectively the average (mean) is £20k. This means if a buyer were to spend £30k on what he is told is a good car then he would be paying above the average. Therefore consumers are likely to decide to go for the average (priced, and quality) car which is the medium-quality at £20k. If a seller has a low-quality car then he will bite your hand off and accept your £20k (making £10k more than he expected), if the seller has a medium-quality car then he will sell at his asking price, but if the seller of a high-quality was offered £20k he would turn it down. Therefore owners of high-quality cars would no longer sell their cars as they wouldn't get their asking price.

Now all the cars in the second hand market are either low-quality (lemons) worth £10k or medium-quality at £20k. The mean value of this is £15k and like above medium-quality car owners aren't going to want to sell at this price and hence they won't be sold. Now this means that the second hand car market consists only of lemons as Akerlof stated.

As we said above there are ways to get around this in the lemon case. The first is offering a warranty, this proves to the buyer that the seller is actually selling a good car as they are willing to pay the cost if the car breaks down. Even if the car does break down it incurs not costs (except not being able to travel) to the buyer. Sellers of low-quality cars wont offer a warranty since they know that they will have to pay-out as their cars are low-quality.

Another way to sold this asymmetric information market failure is by building up a reputation. Generally in 2nd hand car markets the seller is only likely to sell a car once. This means if they claim it to be a good one and it turns out to be poor then they don't loose any reputation or any further business. Whereas if the sale is done through a firm which relies on selling cars to make money then they will be more concerned about their reputation. If they sell low-quality cars claiming them to be high-quality then sooner or later people are going to spread that Company X is terrible and they may eventually go out of business. This means that they are likely to be honest about the quality of their cars. The internet has also helped this happen as it has allowed disgruntled customers to tell other potential customers not to shop with Company X!

Solutions

The solutions above were exclusive to the market for second-hand cars but here are some general solutions for asymmetric information.

Offering some form of money-back guarantee. If the seller offers this then it shows that they believe their product is so good that consumers wouldn't want to return it. This lowers the risk for consumers as if they buy a product and it turns out to be duff then they can return it and get their money back.

Building up brand and customer loyalty and gaining a good reputation. This explains why in the old days banks used to build impressive marble buildings that were large and ostentatious, this was to inform potential customers that they were here to stay (i.e. they wouldn't run off with their money) and that they had plenty of money to build such a large and glamorous branch to give consumers the impression that they were profitable. Today firms may set up shops in high-streets in order to give an impression that they were reputable. Many firms also spend large amounts of money on advertising in order to build up brand loyalty, they are also likely to handle complaints well otherwise people may spread around that the company is bad. The internet and social media has encouraged this and has forced firms to ensure that complaints are handled well and that service in general is good. One example of the effect of social media is when in the UK a soldier (in uniform) was not allowed service in a pub, it caused widespread furore and a campaign to boycott the pub amassed large support on Facebook. 

Government regulation can also work to give consumers certain laws. In the UK laws exist such as the Trade Descriptions Act, that ensure that products that are sold fit the description they were given before purchase. If a trader was to break the law they could face prosecution or pay a fine. 

Institutions could be set up that fight consumers corner. In the UK the Financial Ombudsman looks after customers, and if someone is sold a faulty good and the seller refuses to give a refund or exchange the consumer can contact the Ombudsman who would look into the case.

Page last updated on 20/10/13