Information and the market: Or Hayek v's Akerlof

From first year on, economics students are told that asymmetric information can cause markets to fail. Akerlof's famous example of the used car market is known to all econ students. But does asymmetric information really cause market failure or does it in fact cause markets to exist?

The great Austrian economist Friedrich Hayek would surely argue the latter, markets are the answer to the problem of asymmetric information.

For Hayek markets eliminate the asymmetry by revealing relevant aspects of information in market prices, but not so for the Akerlofs of this world. As Cowen and Crampton (2002: 5) put it "[t]he Canadian plumber's knowledge of substitutes for copper piping influences the French electrician's choice of home wiring through its effect on the market price of copper. For the market failure theorists, however, asymmetry cannot be overcome by exchange precisely because the unequal distribution of information interferes with mutually beneficial exchange." The fundamental point of markets for Hayek is that they utilise dispersed, asymmetric, knowledge in such a manner as to align production plans with consumption plans.

This alignment takes place in three ways: "First, ex ante, prices transmit knowledge about the relative scarcities of goods to various market participants so they may adjust their behavior accordingly. If the price of a good goes up, this informs economic actors that the good has become relatively more scarce and that they should economize on its use. For this reason, participants in the market have an incentive to include the knowledge contained in prices in their actions over time. Second, the price system serves the ex post function of revealing the ultimate profitability or unprofitability of economic actions. Prescient entrepreneurship (in the broad sense of the term) is rewarded with profits; errors are penalized by losses. Market prices, therefore, not only motivate future decisions by conveying information about changing market conditions, but also help market participants evaluate the appropriateness of past market decisions and correct erroneous ones. Seen in this light, the market process is a matter of dynamic adjustment. What is it adjustment to? It is, in effect, adjustment to the gaps between a static equilibrium of universal satisfaction and the many departures from this model that are present in the real world. Each of these gaps between the counterfactual and the factual represent a profit opportunity. Price information is also motivation for profitable real-world adjustment, over time, to the profit opportunities of a particular place." ( Boettke 1997: 25-6)

Also new markets can develop to deal with asymmetric information, if you don't know the condition of a second hand car you take it to the AA and get a report on what's right or wrong with it. If you don't know what maybe wrong with a house you want to buy you can get that checked as well. These services have developed to deal with the asymmetric information in the used car and housing markets. The basic point is that markets constantly innovate, informational asymmetries create demand for product assurance from which profits can be made by alert entrepreneurs. Klein (2001) is one paper which looks at the institutions that have arisen in the market system to mitigate problems of information, quality and certification. The lesson to be drawn here is that while "[m]arket failure theory predicts massive deadweight losses accruing from the trades that fail to take place because of informational asymmetries. In reality, alert entrepreneurs see deadweight losses as potential profits to be earned by removing the impediment to trade." (Cowen and Cramption 2002: 12-3)

So who's more likely to be right, Akerlof or Hayek? Ask yourself, Can you buy a good used car?