Imagine you have to decide which tutor to choose to help you study economics and you don't know who provides better teaching. If you don’t know the tuition fees, how would you decide who to choose? The lack of information, or what we call imperfect information, will probably make your choices harder.
The same happens in many other life situations. If an economic agent doesn't have enough information, it is more difficult for them to make rational choices. This can lead to inefficient market outcomes and even market failure.
What is imperfect information?
Before giving you a definition of what imperfect information is, let’s discuss perfect information and how economists understand it.
Even though perfect information doesn’t exist in the real world, in economics we assume that it does exist in certain cases.
Perfect information occurs when the economic agents are perfectly informed when making their decisions. For example, consumers are aware of the available products, their quality, and prices, the utility they will get from consuming the good, and any other information relevant to their decision-making.
We assume that perfect information exists in perfectly competitive markets. Most market structures other than the perfectly competitive one have imperfect information.
Imperfect information occurs when the economic agents lack information about a good or any other information relevant to the transaction. In this case, for example, the consumers may have partial information about the product quality, which would make it difficult to make a rational choice upon purchase. The sellers may not know the exact utility function of the buyer and may charge too high a price.
Let’s review an example to understand what happens when we have imperfect information:
Let’s assume Gina goes to buy a diamond. She has perfect knowledge about diamonds: she knows how to test for originality, their price per carat, size, colour, and cuts. In this case, the seller won’t be able to sell her a diamond at a supernormal profit, because Gina wouldn’t purchase it. Gina will be able to rationally choose the right diamonds at the right price.
On the other hand, Sarah, who doesn't know much about diamonds, will go to the diamond merchant with imperfect information. She will be unaware of the price and quality characteristics of diamonds. She will trust the seller and buy the diamond at a significantly higher price than the market price. Therefore, she will make an irrational choice due to imperfect information.
Another example of imperfect information is the example of education consultants. Here, the consultants have the knowledge that the students don’t have, leading to an inefficient market outcome.
In recent years, immigrant students applying to universities in the UK have gone to education consultants for help in the process. These consultants charge fees upfront for providing basic information about the courses offered, visa guidelines, documentation requirements, etc.
Furthermore, the consultants attempt to take advantage of the imperfect information that the students have, and mislead them into attending a particular university that financially benefits their business. The consultants focus on earning a good commission from the university rather than adhering to the students’ selection criteria.
When the students don't have full information about the courses, university rankings, curriculum, or the job market, they may end up going to a university that isn’t optimal for them. Hence, they may lose out on the best study option available due to the imperfect information.
The importance of information for decision-making
Consumers need the correct information to maximise the utility from consuming a product.
At times, a consumer may not have perfect information about merit goods and may not consume an optimum quantity. This type of market failure is called under-consumption of the merit good. For example, an individual unaware of the benefits of vitamins may not be willing to buy them.
At other times, the consumer may be unaware of the ill effects of demerit goods, which may result in over-consumption. This type of market failure is called over-consumption of demerit goods. For example, before people were aware of the health damage caused by cigarettes, smoking was widely prevalent.
We can thus conclude that if the consumer or seller doesn’t have enough information, they make a decision based on incomplete information and arrive at an inefficient market outcome, which may lead to market failure.
Until 2019, Coca-Cola, the highest consumed soft drink in the USA, did not mention its sugar content publicly. Because the consumers were unaware of the high sugar content and the possible risks associated with the product, they consumed it disproportionately. This over-consumption has made the public overweight, which puts a significant strain on the healthcare system.
Perfect vs. imperfect information
Here you have a quick summary of the differences between perfect information and imperfect information.
| Perfect information | Imperfect information |
Definition | Perfect information is when every market participant has complete information. | Imperfect information is when either the buyer or the seller has incomplete information. |
Market structure | Perfect information exists in a perfectly competitive market. | Imperfect information may exist in a monopoly, oligopoly, or monopolistic competition. We assume that it exists in all other market structures apart from perfect competition. |
Existence | Rarely exists. | Quite common. |
Knowledge about the product | Buyers and sellers have perfect knowledge about the product and resource market. | Either a buyer or a seller lacks some knowledge about the product and resource market. |
Transaction risk | As the consumers make an informed decision, the transaction risks are low. | The consumer may not be able to make an efficient decision due to incomplete information. Hence, the transaction risk is high. |
Decision making | Based on complete knowledge. Fully informed decision-making. | Based on the available partial information. Partially informed decision-making. |
Asymmetric information
There is a difference between imperfect and asymmetric information. To understand the difference, it is useful to note that imperfect information refers to a general lack of information. Asymmetric information, however, is a type of imperfect information when one party in a transaction has more knowledge than the other party and the other party cannot access the knowledge that the former party has. This leads to an inefficient market outcome.
Two particular types of asymmetric information result from:
1. Hidden actions (this is called moral hazard)
2. Hidden characteristics (this is called adverse selection)
Asymmetric information is a type of imperfect information where one party has significantly more information than the other. The other party cannot access the knowledge that the former party has.
Hidden actions - moral hazard
Moral hazard occurs when an economic agent alters their behaviour in a situation when the cost of the risk of such behaviour is borne by another party.
The most famous example of moral hazard is the employer-employee relationship. In this example, the employee has the information about the amount of effort they put into their work. The employer cannot access that information.
If the employee knows the extent to which they can do a sufficient amount of work not to be fired, they will choose to not put in the maximum effort. This is called ‘shirking.’ In the absence of perfect monitoring, the employer cannot distinguish between the real maximum effort that the employee is able to put into their work and a sufficient level of effort that the employee chooses to put in. This results in a sub-optimal level of effort from the employee resulting in an inefficient market outcome.
Hidden characteristics - adverse selection
Adverse selection occurs when the seller possesses more information than the buyer does in the transaction. The cost is borne by the buyer as they may buy a substandard product.
The most famous example of adverse selection was shown by George Akerlof in his 1970 paper titled ‘The Market for Lemons: Quality Uncertainty and the Market Mechanism.’ In this example, the seller sells second-hand cars and has more information than the buyer. The buyer cannot access this information.
The consumer may not have complete knowledge about the quality of a used car and may trust the information given by the seller. However, at some point, the seller may take undue advantage of the situation and sell defective used cars. The defects may not be visible to the naked eye and can be hidden with basic repairs.
Sometimes the repaired cars will look as good as new. Hence, the buyer may be attracted by the car’s outer appearance and decide to buy it. This is due to the asymmetric information the consumer has about the car's parts and the repairs it went through. Hence, the buyer will get the defective car at a higher price than what it actually should cost.
Information in decision-making in economic theory is fundamental. Imperfect information makes it difficult for the economic agents to make rational choices and can result in market failure. There are various mechanisms employed in the real world to deal with the problem of adverse selection and moral hazard.
Imperfect Information - Key takeaways
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