What Happens in a Market When Information Is Imperfect?

• CONSTANTIA PALA

Introduction:

In the study of competitive markets it is often assumed that consumers and producers have perfect market information upon which to make their economic decisions. This is known as symmetric information, where consumers and producers have perfect and equal market information on a good or service. Assuming that consumers and producers act in a realistic way, it will lead to an efficient allocation of resources. (Gavin 2008). However, in reality, consumers and producers have imperfect and unequal market knowledge upon which to make their economic decisions and this could lead to a misallocation of resources. The three competitive market models (monopolistic competition, oligopoly and monopoly) definitely have characteristics which prove that information in these markets is imperfect or asymmetric. For instance, it can be argued that in a market where a monopoly exists, the consumers and new firms which wish to enter the market, have imperfect knowledge about the monopoly’s pricing and output strategies.

Main Body:

Information failure:

Some examples of information failure can be caused by inaccurate, misleading or complex information. For example, when you are purchasing a used car, you certainly know less about any problems the car might have, than the person selling it. Hence, after a short usage period the car might stop working due to a technical problem you could have known if information were symmetric. In addition, when a firm hires a new employee, that worker may have a much better idea about his or her ability than the firm. (Morgan, W., Katz, M. and Rosen, H., 2006). The firm on the other hand can underestimate or overestimate the employee’s abilities and this might have an impact on his salary. Whenever one side of the market has better information than the other, the asymmetric information issue arises. Furthermore, addiction is one of the main examples of information failure. Nowadays, technology is becoming more and more present in the consumers lives. The percentage of the people which are obsessed with certain goods is much larger than it was ten to fifteen years ago. A very recent example is the release of the new iPhone 6. Thousands of people were waiting in long queues to purchase the new apple product. (Williams, R., 2014) As researches have shown most of the people waiting in line were not aware of the functions of the new mobile phone and didn’t even need a new phone since they had purchased the previous iPhone model which was released a year ago.

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Also, another example of incomplete information can be created by misunderstanding the true costs or benefits of a product. For instance, insurance companies do not know much about buyers’ health problems. People with greater hidden health problems are more likely to purchase health insurance than other people and the price of health insurance reflects the cost of a sicker-than- average person. As a consequence, people in average health may be discouraged from purchasing health insurance by the high prices set by the insurance companies. (Mankiw, N.G. and Taylor, M.P ,2014). Finally, imperfect information can be due to ignorance. If the market participant is aware that better information is available, information becomes another need or want. Information may be acquired through an economic transaction and becomes a possession that is a cost to the buyer or seller. Useful information is available as a market product in forms like books, media broadcasts, and consulting services. (Stengel,D.N.,2012)

Stock and financial markets:

Moreover, imperfect information can be also seen in the stock and financial markets. Financial markets and specifically stock markets is one of the markets where the expectation of availability of full information for all members is ignored so that the situation leads to establishing the market forces. The role of information has been ignored in these models. The main role of the balance of information to all individuals is that it ignores the theoretical behaviours in rational social learning, which can improve the individual behaviour in steps of making decisions. For rational social learning market, participants can examine two types of information in their decisions. The first one, is the general information which is available to all individuals and the second one is private information, with personal signals which is only available to certain people. (Mahmoodzadeh,M., Ghavidel,S., and Mousavi,M.H.,2014).

Labour, foreign exchange markets:

Asymmetric information in the labour market is a situation where employers do not know the future output of the new employees. In addition, migrant labour definitely has asymmetric information since in some cases, they are being employed under illegal conditions. They do not have enough information and knowledge about the employment laws of each country and as a consequence, they might be underpaid or overworking than the average labour of that country, or for less money than the national minimum wage.

Demand and supply markets:

In the demand and supply markets, the only market that consists of both the producers and the consumers having perfect knowledge on the product and the market is perfect competition. This market has very low barriers to entry and exit and hence producers find it cheap and easy to pop in or out of the market. This means that the firm has access to this information by including the latest main example of perfect competition is the market for vegetables. Anyone can sell and grow his own garden and every vegetable seller sells his goods on relatively the same prices as everyone else. A monopolistic competition can be compared to a perfect competition in terms of barriers to entry. In this market, the barriers to entry and exit are relatively low. However, when it comes to imperfect information, the knowledge on this market is widely spread between participants, so it is unlikely to be perfect. This can be inferred from the dining industry. Before attending a restaurant, consumers can get different opinions and read different reviews about the menus and the restaurant in general before making their final decision. In addition, each firm makes independent decisions about prices, output which are based on its product, its market and its costs of production. Finally, there are usually a large number of independent firms competing in the market. (Economics Online,2013). Overall, information in the perfect competition market is assumed to be symmetric while information in the monopolistic competition is assumed to be relatively imperfect.

To continue with, oligopolies and monopolies are the main forms of competition in the demand and supply market where information is asymmetric. These two types of competition can maintain their position of supremacy due to the high barriers to entry and exit. A monopoly exists when there is only one big firm in the industry. But whether an industry can be classed as a monopoly is not always clear. It depends how narrowly the industry is defined. For example, a textile company may have a monopoly on certain types of fabric, but it does not have a monopoly on fabrics in general. The consumer can buy fabrics other than those supplied by the company. (Sloman,2008). Moreover, monopoly has imperfect knowledge and the monopolist may know more than the consumer and can exploit this knowledge to its own advantage. Also, prices are higher and quantity is lower under monopoly compared to perfect and monopolistic competition.

Figure 1: A monopoly market structure (Economics online, 2013)

As it can be inferred from Figure 1, the monopolist makes supernormal profit (PABC) at the expense of the consumer surplus. The consumer pays a higher price (P) than the price he could have paid if he had perfect knowledge of the product and the market in general. We can also say that this is one of the main reasons that the government monitors and controls the development of monopolies in the market.

As mentioned above, the same asymmetric information exists in an oligopolistic market. Oligopoly is a market which has a few sellers supplying many buyers. Each seller recognises that prices can be controlled to a certain extent and that competitors’ actions will influence profits. Therefore, oligopoly has imperfect information about rival firms’ price and output decisions. For instance, major airlines like British Airways and Air France operate their routes with only a few close competitors. With only a few firms in oligopoly dominating an industry, there is a high concentration ratio firms in an oligopoly tend to avoid price competition; oligopoly market is also characterised by non-price competition. (Sloman,2005).

The behaviour of oligopolies can be examined using the Game Theory. It is a method used by economists to examine strategic interaction of markets. Each firm in an oligopoly should consider how its decision might affect the production decisions of all the other firms. (Mankiw, N.G. and Taylor, M.P , 2014). Asymmetric information can also be analysed with game theory. For example, when deciding whether to cut or increase prices, firms will be uncertain about how their rivals will behave and react. They will have to make decisions whilst trying to second guess how other firms will respond. A symmetric game is a game where the payoffs for playing a particular strategy depend only on the other strategies employed, not on who is playing them. When the identities of the players can be charged without charging the payoff to the strategies, means that the game is symmetric. However, asymmetric games are games where there are not equal strategy sets for both players. It is possible, for a game to have equal strategies for both players, yet be asymmetric.

Conclusion:

To conclude, imperfect information can be seen in the demand and supply market, labour market and financial and stock markets. Markets may not provide enough information because, during a market transaction it may not be in the interests of one party to provide full information to the other party and as a result a market with imperfect information leads to a market failure. Firms in all three competitive markets have ‘market power’, which means they face a downward-sloping demand curve, and so can choose the price of their product rather than simply accept a ‘market price’ like the perfectly competitive firm.(Hill, R. and Myatt,T.,2010).

References:

Economics Online, 2013, Monopoly. [image online] Available at: http://www.economicsonline.co.uk/Business_economics/Monopoly.html [Accessed on: 12/10/2014]

Gavin, M.G., 2008, Economics: Competitive Markets: How They Work and Why They Fail. Oxfordshire: Philip Allan Updates.