Is Informational Asymmetry a Market Failure?

Lemons absolutely exist, but so does Carfax.

We all seek an end to fraud. Aside from being inherently wrong, this type of crime also undermines the economy. Yes, mutual gains from fraudulent transactions can still be made ex ante (looking ahead). This is so for all commercial interaction, without exception. Each side, even in fraudulent interactions, expects to gain in utility from the purchase or sale or rental or borrowing or lending, etc. However, fraud plays havoc with utility ex post (after the fact). Only one side can gain; the other is the clear loser. All men of good will must necessarily oppose fraud, as it is in opposition to human flourishing.

How, then, to eradicate fraud? One possibility is to declare informational asymmetry a market failure, and to have government address this problem. One way to do so would be for the state to educate the ignorant. Another equally positive approach would be to dumb down the smart. Here we would employ Kurt Vonnegut’s “Handicapper General.” (Many critics think, not without good reason, that this is what public education now accomplishes.) A third option would be to do a bit of both. After all, the goal here is not to improve information; rather, it is to equalize it, amongst all of us.

Best of luck on this.

What positive can be said of such a silly proposal? One argument in its favor is that if there were full symmetry in terms of informational holdings, then, from a praxeological point of view, there could be no such thing as a swindle. If both parties had exactly the same knowledge of all relevant considerations to bring to the market, then it would be a logical contradiction for one to be able to take advantage of the other’s relative ignorance in any such manner.

But this is a highly problematic way of dealing with the problem. For one thing, only a small percentage of all commercial dealings are criminal in this way. Yet, of the almost 8 billion people now occupying the third rock from the sun, it would be difficult to reject the notion that there are roughly an equal number of people for whom it may be properly said that they have different amounts of information. Asymmetrical knowledge is here to stay, and there is nothing, apart from the most radical science fiction notions, that anyone can do about it. It is also difficult to attribute much of a causal connection between this unequal state of affairs and con men, since virtually every commercial interaction bespeaks informational asymmetry, and very few trades, happily, are fraudulent.

Which market forces come to bear to ameliorate this problem? Just as the free enterprise system internalizes externalities, so, too, are there institutions that, happily, radically reduce the incidence of commercial scams when informational disparities are particularly rampant. For example, risk regarding sales of “lemon” automobiles is reduced by Carfax. This role is played by the gold standard in monetary transactions. Then there are “Consumer Reports” for items of that nature. Similarly, the function of Moody’s, Standard & Poor’s, and Fitch is to accomplish much the same goal in the stock and bond markets.

In sum, there ain’t no such thing as a market failure, the claims of most neoclassical economists to the contrary notwithstanding, certainly not this particular one.

First published here.