Capitalism and Asymmetric Information

Capitalism is a wondrous human institution for the mutual betterment for all in society. Yet, critics often insist that market systems enable sellers to take advantage of buyers, because those on the demand-side often lack the specialized knowledge that suppliers possess, thus, enabling a possible exaggerated misrepresentation of what is being offered for sale. What is missed is that market competition generates the incentives and opportunities to earn profits precisely by not misinforming or cheating the buyer.

A number of economists, among the most notable being the 2001 co-recipient of the Nobel Prize, Joseph Stiglitz, a professor of economics at Columbia University, have argued that market economies suffer from an inherent inefficiency and potential injustice due to the existence of “asymmetric information.”  A core element in his theory is that individuals in the marketplace do not all possess the same type or degree of knowledge concerning the goods and services being bought and sold.

Some people know things that others do not. This “privileged” information can enable some to “exploit” others. For instance, the producer and marketer is likely to know far more about a product’s qualities, features and characteristics that he is offering on the market than most of the buyers possibly interested in purchasing it.

Perfect Competition and Perfect Knowledge

By withholding or not fully informing the potential buyer about all of the qualities, features and characteristics of his good, he may succeed in creating a false impression that makes the consumer have a greater demand for it and a willingness to pay a higher price for it than would be the case if that consumer knew as much about the good as the seller knows.

This argument is a partially reasonable response to the unrealistic assumptions of the “perfect competition” model of the typical mainstream economics textbook. One assumption is that each seller is, respectively, considered too small a contributor to the supply of a good offered on a particular market to be able to influence the price at which he sells, and, thus takes that market’s price as “given,” with merely adjusting his output to that point at which his (marginal) costs are equal to his (marginal) revenues.

Another assumption is that every market participant in each market possesses a “perfect” or “sufficient” knowledge to never pay more as a demander or accept less as a supplier that the “objective” market conditions dictate and require. This also assures that all markets, all the time, are in or rapidly converging to a perfect long-run equilibrium with neither profits earned nor losses suffered. (See my article, “Capitalism and the Misunderstanding of Monopoly”.)

Markets Integrate and Coordinate Decentralized Knowledge

There is no doubt that in a system of division of labor there is an accompanying division of knowledge and, therefore, an asymmetry of information about things bought and sold by those on the demand- and supply-sides of the market. This is a theme in theories of the market process long ago explained by economists in the “Austrian” tradition, most especially by Friedrich A. Hayek (1899-1992), who also received a Nobel Prize in Economics in 1974.

The Austrians have long emphasized that competition is a “discovery procedure” through which individuals find out things never known or imagined before. The peaceful rivalry of the marketplace creates the incentives for entrepreneurs to be unceasingly alert to profit opportunities and to see possibilities that others either have missed or not thought of before. The unknown or barely perceived become seen and understood, and then taken advantage of in the form of new, better, and less expensive products offered to the consuming public.

The purpose of competitive markets and price systems is precisely to provide a way to integrate and coordinate the dispersed and decentralized knowledge in any society possessing a degree of complexity. This same competitive market has also found ways to reduce and overcome the asymmetry of consumer versus seller knowledge concerning the qualities, features and characteristics of goods, and thereby to reduce the potential and possibility of “exploiting” what the seller may know at the expense of the market buyers.

Search Goods and Judging Product Quality

In explaining how markets do this, economists sometimes distinguish between two types of goods offered and sold on the market: search goods and experience goods. Search goods are those that can be examined and judged by the potential buyer before a purchase is made. For instance, suppose that a supermarket advertises that perfectly ripened bananas are available and on sale in their store. A consumer can enter the supermarket and fairly reasonably judge whether the quality of the good matches what has been promised in the advertising before buying it.

If examination shows that the bananas are either non-eatable green or over-ripened brown, the consumer can walk away without spending a penny on a product that has not met what was promised. By falsely or incorrectly advertising, or even unreasonably exaggerating in its advertising, the business runs the risk of not only losing that sale but the loss of its brand name reputation, with that consumer never returning to that establishment again. Plus, that person can tell others what his “search” of the good came up with, potentially leading to those others not trusting that businesses advertising without inspecting the good themselves.

This creates a self-interested incentive on the part of such sellers to practice “true in advertising,” or suffer the loss of some their regular customers upon whose repeat business their long-term profitability is dependent.

Experience Goods and Market Safeguards

Experience goods are those goods whose qualities, features and characteristics cannot be really fully known and appreciated without using the product in question for a period of time. Think of an automobile; you can go for a test drive, but your own best judgment of its safety, reliability and handling cannot be really known without driving the car in various weather and traffic conditions over a period of time. Or think of a bed mattress; you sit down and bounce on it, or stretch out and lay down on it in the furniture showroom, but you cannot really know if it will give you a comfortable and restful sleep every night until you’ve gone to bed on it for a period of time. The same applies to many goods, such as household appliances, for instance.

The competitive market’s response to this uncertain and imperfect knowledge on the part of potential buyers has been the seller and manufacture’s system of product warranties that enable the buyer to return the product over a period of time for his or her money back, or a replacement at no extra cost to the buyer.

It is, again, in the seller’s own self-interest to make sure that the product is what has been promised and is reliable in its working order and performance, otherwise, once more, the seller and manufacturer run the risk of losing their brand name reputation concerning quality and trustworthiness. Plus, if a warranty has to be fulfilled it is the manufacturer or seller who is forced to eat the cost of replacing the unit returned due to malfunction or failure to match buyer expectation, thus cutting into their own profit margin.

Market Uncertainty and Franchise Businesses

But what about those situations in which concern about repeat business or brand name reputation do not seem to be as relevant? For instance, suppose you are traveling on business or vacation and are passing through some town you are highly unlikely ever to see again.

You’re hungry for a meal or a place to stay for the night. How can you know about the quality of the meal in the local “Joe’s Greasy Spoon,” or the promised bedbug-free mattress in any of the rooms in the local “Bates Motel”?

The market has provided consumer information about the qualities, features and characteristics of such products and services to overcome this inescapable imperfect knowledge in the form of chain stores and franchises. You may never eat or sleep again in that particular town, but you will likely eat and sleep away from home somewhere at sometime again in the future.

The sight of the MacDonald’s “Golden Arches” or the sign for an IHOP (International House of Pancakes) anytime, any place, tells you the quality and variety of foods that you can have in any of their establishments, regardless of where its location in the United States or even the world. The same applies to seeing the sign for a Motel 6, or a Holiday Inn Express or an Embassy Suites, or a Hilton-family hotel. You may never again go to that particular MacDonald’s or Holiday Inn, but if you travel you may very well eat or spend the night at some other chain franchise of that company.

Another instance of this is, for instance, Midas Mufflers. An automobile driver can stop in any Midas store in the country, and know that if there is a problem with the muffler or its installation, he can return it to any other Midas outlet to have it replaced or reinstalled for free under the warranty. (And each Midas retail store has an incentive to get the installation “right,” because if another store has to correct their mistakes, the second store sends the bill to the first store for the costs of doing so, under the terms of the franchise.)

Getting it right the first time and making sure that every franchise member meets the franchise requirements in doing so is important to the “mother company” to assure the repeat business and brand name reputation upon which its own revenues are dependent. Thus, each chain store and franchise is required to meet standards of quality and variety that enables the consumer to have a high degree of confidence and reduced knowledge uncertainty of what he or she is getting when they enter any of these establishments regardless of where it may be located.

What makes this practice in the market consistently happen and successfully relied upon? Market competition and the self-interested profit motive.

Con Men Are Always with Us, Free Markets Constrain Them

Are there con men, hucksters and cheats? Of course there are. They existed in ancient Athens just as they exist today. There are always people who will try to dishonestly get what others have, when doing it that way seems easier and less costly than through honest production and trade.

The question is not whether human nature can be transformed to eliminate this aspect of human conduct. The question is, are there market institutions and incentives that can systemically reduce this type of behavior and, instead, generate more honest and properly informed human interactions?

And the answer is, yes. In fact, most of these positive incentive mechanisms have emerged and evolved out of the competitive market process, itself. These “market solutions” to the “social problem” of asymmetric information were discovered by market participants themselves to be profitable ways of gaining consumer trust and confidence and business, without any government command or imposition. Plus, their discovery and their practiced institutional forms could never have been fully anticipated or imagined in their full detail before and separate from the competitive market processes that have generated them.

Government Failure and Asymmetric Information

Of course, what is rarely pointed out or emphasized by those who worry about the problem of asymmetric information in society is its far more likely danger and abuse in the arena of government action and intervention.

In the marketplace, the disappointed or disgruntled consumer who considers that a seller has been less than truthful or trustworthy concerning the product the buyer has bought can immediately or in relative short-order stop doing business with the supplier with whom he is disappointed. This is not so in the political arena.

If a voter considers that a politician or the bureaucrats answerable to him have failed to meet up to their promises or have seemingly deceived him in the face of the actual policies those in the government have undertaken after an election, he must continue to fund their activities in the form of the taxes that that voter is forced to pay, as well as to obey the rules and regulations they have imposed on him or others with whom he may desire to do business.

In the marketplace, the consumer may turn to other possible competing providers of the good or service he wishes to buy and use, if a particular seller has appeared to deceive him with false or incomplete or exaggerated information about the good or service in question.  He does not have this option in the political arena.

The government often monopolizes or narrows the availability of alternative providers through interventions that limit or prohibit competition in some corner of the market. The frustrated voter cannot supply the type of “negative feedback” concerning his disappointment with the promised product the same way he can by withdrawing his business and shifting to another supplier in a more freely competitive market. Indeed, he may have to continue to use the misrepresented or faulty government-supplied or regulated product rather than face doing without it.

In the marketplace, it is usually fairly clear who is the seller who has marketed and misrepresented the product that has aroused the ire of the buyer. The consumer can more or less easily pinpoint the seller who is responsible for the deceit or inappropriate exaggeration of the product bought and used. But with the government, layers of bureaucracy and indirect chains of responsibility in the labyrinth of the political structure of decision-making, enables those in political power or authority to more easily hide from view those upon whom the charge of lies and fraud should fully fall.

And, finally, in the marketplace, the individual disappointed with presumed misrepresentation or less than sufficient information from a seller can inform others about his experience, but he does not need the approval or agreement of others to change his own pattern of buying things and from whom. He just stops doing business with the seller with whom he is dissatisfied, and finds a more attractive trading partner.

But in the political arena, to change those holding political office and determining the government policies considered by that individual to be deceitful and undesirable requires him to persuade enough other voters in the society so that a change may be made in who holds political office and what policies may be implemented when, and only when, the next elector cycle comes around.

It is capitalism and the competitive market process that generates solutions to the knowledge problems of the society, including the “informational asymmetry” that naturally follows from any developed social system of division of labor. All that is basically required, as has been known since the time of Adam Smith in the 1770s, is recognized and respected individual rights to life, liberty and honestly acquired property, enforcement of all voluntary contractual agreements, impartial and biased rule of law, and constitutionally limited government.


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One reply on “Capitalism and Asymmetric Information”
  1. says: MrVeryAngry

    Markets also develop intermediary services. Intermediary services like lawyers or accountants of financial advisers or Which! are ‘information adjustment services’.
    Job done.

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