Information Asymmetries 1

By Leslie Pratch

By Leslie Pratch

I am not an economist but I certainly was exposed to price theory in business school at the University of Chicago. Recently, I reread a lecture Milton Friedman gave during the 1950s. He argued that a free market is a situation is one in which transactions are voluntary, bilateral, and mutually informed, the idea being that everybody going into the marketplace is well informed believing the transaction will make them better off.

Over the past 10 years, economists have worked on information asymmetries, situations in which the parties are not mutually and equally well informed. The models assume that at least one party to a transaction has relevant information whereas the other does not. Some economists argue that the economy operates at an optimum level (whatever "optimum" means) assuming full employment (i.e., an unemployment rate near 5%) even under conditions of asymmetric information. "If we"re smarter, we should be richer, right?"

From an economic point of view, from a price theory point of view, there may well be theoretical free market support for that argument. But that doesn"t satisfy me from an ethical point of view. If parties are not mutually and equally well informed, those with more information are likely to wind up with all of the wealth and those with less information will wind up with none of the wealth.

Take subprime housing loans or credit card offerings. The bank says, "All the terms are right there" but when do consumers really have the information? Credit card offerings are turgid, long, and have tiny print. The agreements give the banks all sorts of power and many consumers have gotten into trouble because they lacked information. I get credit card offers at 0% interest until March 2009. Implicit is that after March the rate goes to prime plus 9.5%. Many consumers are not savvy enough to grasp that implication. It is up to consumers to get smarter. Bernard Madoff was recently sentenced to 150 years had information about what he was doing that most of his clients did not have. Maybe his clients should have been smarter. I am heartened by news of rules for mortgage lending that protect consumers (reported in July 24th"s Wall Street Journal) which suggest that Richard Thaler"s proposal in the New York Times is being enacted.

Institutions work hard to develop information and that information is valuable. The SEC and to a far greater extent, the accounting profession, has a long history (longer than 600 years in the case of double entry accounting) where the essence of the activity is to develop, systematize, and certify information. The accounting profession is sanctified by government regulation (e.g., in recognizing FASB). The government sees it proper to disseminate some information. But when information is not shared, information goes into the direction of greater and greater imbalance. A market in which increasing numbers of parties are deprived of information implies that the performance of the economy will get worse.

The free marketers have said "We want to maximize total wealth creation" but they don"t take into consideration the distribution of income. Influence the income distribution in ways that the market would not cause is in the realm of political philosophy or social policy; it is not the economist"s job.

Another question economists try not to address is "Over what period of time?" If a highly unequal distribution of wealth and income leads to one level of total wealth output, and a more equal distribution leads to better wealth output would economists say the latter is better?

Information asymmetries have values implications that we should care about (assuming we are not economists). Not interfering with any activity, including the creation and distribution of information is the definition of an efficient market. All information is impounded in a price of a commodity. Greater transparency would be consistent with those who believe intensely in the free market. But relying on the market place to produce a socially satisfactory income distribution is not okay by me.

by: Leslie Pratch

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