Information failure

When a market fails it means that the free operation of market forces does not lead to an efficient allocation of scarce resources.

While there are several types of market failure, perhaps the most significant one involves ‘information failure’ given that in all other market failures some form of information failure exists.

Market failure of government failure?

Market failure

Information failure as a 'market failure' refers to a situation when economic agents – producers and consumers – do not possess perfect or complete information regarding either the cost or the benefit resulting from a market transaction.

While they may possess a large quantity of information, the quality and usefulness of this information may not be sufficient to allow rational decisions. When participants have perfect knowledge in terms of both quantity and quality we assume that they act rationally and in their own best interest, and that markets work effectively.

Government failure

Information failure can also be a form of 'government failure', when a government or its agencies take decisions based on limited or faulty information. This can result in policy failures and unintended consequences.

In economics, information failure is described in different ways, including 'imperfect knowledge', 'asymmetric knowledge' and 'information gaps'. While they have similar meanings, they are often used in slightly different contexts.

Asymmetric knowledge

Asymmetric knowledge arises when one party in a transaction has more knowledge than another party, and this puts them at an advantage in terms of negotiation and the transaction. For example, it is suggested that, for many years, cigarette manufacturers knew of the health risks of smoking while smokers, in general, were less aware of the specific health risks - until more information was provided as part of anti-smoking legislation. Clearly, a lack of information (or information gap) resulted in irrational decision-making by smokers.

Examples of information failure

Under-perceiving the private cost of consumption

When consuming some goods or services, the cost associated with consumption or use of the product may not be fully known. For example, with demerit goods such as alcohol and cigarettes the private cost to the individual, in terms of personal health, is unlikely to be known at the point of consumption. Only over time with the health effects emerge, but the consumer may have already damaged their health long before this become apparent. In this context, free market fail to ensure that individuals have complete knowledge of the private costs of consumption.

Under-perceiving the external costs of consumption

When goods are consumed other individuals, known at third-parties, may also be negatively impacted. Purchasing and driving a car is likely to generate carbon emissions, which can impair health and reduce economic wellbeing. The ‘external’ costs are unlikely to be appreciated unless that become ‘internal costs’ – in which case individuals might take them into account. This is the central reason what such goods are taxed.

Under-perceiving the private cost of production

When firms start-up, and produce, they will create business plans best on the best available information. However, it is unlikely that the plans and forecast will be accurate given that many variables can change in an unpredictable way. This is the case with the Covid-19 pandemic. As a result, most firms had to increase their production costs to ensure correct social distancing, as well as experience a significant fall in revenue.

Under-perceiving the external cost of production

Production may generate various external costs, including pollution, congestion and waste. The single firm is unlikely to be aware of all these costs, given that they may not be immediately apparent or measurable. Indeed, some costs may be completely unintended and hence not included in any planning.

Over-perceiving the private benefit of consumption

Many purchases are made with a belief that they will provide a certain level of benefit, or utility. However, perhaps as a result of persuasive adverting, it is common to make purchases which do not live up to expectation. These goods and their either scrapped, given away, or stored.

Over-perceiving the private benefit of production

The private benefit of production refers to the profits available to firms once they have covered their costs. Failure to understand costs or expected revenue is a source of considerable information failure for firms, especially new and small firms.

Moral hazard

Individuals and organisations with superior knowledge may exploit the fact that they know more than the other party and engage in illegal or unethical behaviour. Both buyers and sellers can exploit their superior knowledge. For example, property sellers might not reveal all they know about the safety of the electrical wiring in the hope of selling the property at its maximum price, while the purchaser of an online product make seek damages or a discount for faulty products, which are not faulty, but it would be too difficult or too costly for the seller to have this fault checked and confirmed.

Dealing with information failure

Consumers

Risk-averse consumers may take steps to limit information failure by informing themselves as much as they can. The internet has enabled quick searches of products, and site like Trustpilot provide information which might help consumers make for rational decisions. However, more information does not necessarily lead to more efficient decision-making as the ‘quality’ of the information is also significant.

Firms

Firms can take steps to reduce information failure in several ways. Market research will provide vital information about consumers, competitors and current market conditions. However, this information is unlikely to be complete, or always relevant to the current situation of the firm. In specific industries, firms may request detailed information from consumers, including medical history (in the case of life insurance companies.)

Government

As elected representatives of a country’s citizens it is the government’s responsibility to introduce measures to reduce information failure. Government can pass laws to force economic agents to reveal all the information they know, impose fines when laws are broken, or levy taxes on goods where information failure is suspected.

Examples of specific measures include:

  1. Forcing food manufacturers to label their products accurately, including the alcoholic content of drinks and the sugar content of drinks and food.
  2. Requiring that retailers hide demerit goods such as cigarettes behind sliding screens.
  3. Requiring that potential employees submit themselves to various checks, including checks on teachers and policemen.
  4. Forcing sellers to provide guarantees and other safeguards in the event of faulty goods.
  5. Imposing taxes on demerit goods, such as alcohol and tobacco products.
  6. Imposing minimum prices on demerit goods.
  7. Subsiding merit goods, such as education and healthcare.

Externalities

Why are externalities a market failure?

Externalities
Demerit goods

What are the remedies for demerit goods?

Demerit goods
Welfare

How does equilibrium create welfare?

Welfare

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