Imperfect Information

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:

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.

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

Correct and proper information plays a vital role in decision-making in any market structure, labour market, and even capital market.

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.

Perfect vs. imperfect information

Here you have a quick summary of the differences between perfect information and imperfect information.

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)

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.

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.

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.