Monday, October 16, 2006

Information is Asymmetric: market vs government failure

When a market left to itself does not allocate resources efficiently, interventionist politicians usually allege market failure to justify interventions. Neo-Keynesians have identified four main causes of market failure: the abuse of market power, externalities, public goods, and asymmetric information. My concern in this blog is with the fourth reason for market failure, asymmetric information. Perhaps I will be able to discuss the other three some time later.

Information becomes asymmetric when someone knows more than somebody else. But someone always knows more than somebody else. So information is unavoidably asymmetric. But what interests me is that this situation can make it difficult for the two people to do business together, which is why economists (especially those practicing game theory) are interested in it.

Transactions involving asymmetric (or private) information are everywhere. A government selling broadcasting licenses does not know what buyers are prepared to pay for them; a lender does not know how likely a borrower is to repay; a used-car seller knows more about the quality of the car being sold than do potential buyers. This kind of asymmetry can distort people's incentives and result in significant inefficiencies. Some say this is market failure, and therefore grounds for intervention.

Kenneth Arrow, a Nobel Prize-winning economist, said that free-enterprise economies under-invest in research and development because of risk. In the "ideal socialist economy" government would supply such information free of charge, thus separating the use of and the reward for producing such information.

The idea is that we get markets not to fail by government intervention. But this, as has been pointed out by the economist Harold Demetz, is to indulge in what he calls the "Nirvana Fallacy," whereby we compare allegedly imperfect real markets to imaginary governments that lack even the smallest imperfection.

To setup my argument, I think it is important to recall Occam's Razor, which says that "entities should not be multiplied beyond necessity." This heuristic maxim encourages economy, parsimony and simplicity in theories. Economists, of all people, should know most about this. My point is that if markets have imperfections, and are alleged to be corrected by government, then government must have fewer imperfections than markets in order to meet the standards of parsimony. An imperfect government correcting an imperfect market would be multiplying entities beyond necessity, which we want to avoid.

The burden of proof is not upon the free market to prove it doesn't need corrections. The burden is upon the government since it is the entity making the case for correction. If government cannot meet the parsimony standards, then we give our presumption to the free market.

Joseph Stiglitz is probably one of the most prominent proponents of government intervention. In particular, Stiglitz has written many papers on informational problems in markets. He once claimed that markets are "not perfect aggregators of information". From this, he concluded that we need a greater understanding of how central authorities use information before we can tell if they use information better than markets.

Stiglitz arrived at the conclusion that governments can improve upon welfare even when it faces serious informational constraints, because its incentives and other constraints are better than in markets. He notes that, upon embarking on his venture into the public sector, some friends of his suggested that he might return from Washington "a bit more jaundiced about the role of government." This did happen. During his tenure in the Clinton Administration, Stiglitz identified four significant problems with government: commitment problems, bargaining problems, imperfect competition, and last but not least, asymmetric information. Stiglitz now says that these problems prevent the government from implementing efficient policies. He also contends that incentives for secrecy in government are central to these problems.

Governments, not just markets, suffer from imperfections. Stiglitz now has the knowledge of how government uses information--knowledge that he lacked when he worked for the World Bank. He says,

"Making government processes more open, transparent, democratic and more participation and effort at consensus building is likely to result not only in a process that is fairer, but one with outcomes that are more likely to be in accord with the general interests. Perhaps we can bring efficiency to government."

Perhaps. But why should we make this effort? If government has serious failings that prevent its efficient operation, should we not at least consider free market capitalism as an alternative? Or are we for some reasons obligated to bend over backward to make sure government works efficiently?

Objective scholars, if Stiglitz is one, concerned only with economic efficiency, ought to be faithful to just that. Instead, Stiglitz holds out hope that we can improve upon government. Why doesn't he hold out the same hope for free markets? This illustrates his bias.

If we are concerned with the allocation of scarce resources, we are primarily concerned with economic efficiency. Stiglitz has shown that government intervention adds an even further imperfection to the process of allocating scarce resources. The government has the same problem with asymmetric information. It has an incentive for secrecy, just as the competitive firm does. But using a secretive government to correct the secrecy of firms only magnifies the problem and the secrets become much larger. Therefore multiplying inefficient entities does not make them more efficient. As an advocate of consumer awareness, what disturbs me the most is that consumers are hurt most when this happens.

Government's purpose of intervening conditions of asymmetric information was, in the first place, to increase consumer and businesspeoples' awareness, which leads to better allocations. But government is not a necessary entity to ensure this happens. The free market provides this information itself. If the consumer wants information that the seller is not willing to give, she can always consult a consumer report. Even for risky investments in research and development, the market can provide the information in the form of CPI and PPI predictions, "whisper numbers" and other information. Since it is profitable to be in the business of investor and consumer reporting, the problem of asymmetric information corrects itself in the free market and multiplying government simply multiplies inefficiencies.

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