Failures of Capitalism: Incomplete or Asymmetric Information

What happens when consumers cannot tell a good and bad product apart?

In classic economics it is assumed that both buyer and seller of a product know everything there is to know about the quality of the product, or that this is a good enough approximation to reality.

However frequently the buyer or the seller knows a lot more about the product or service for sale than the other party.

Why does this matter? Imagine a market for used cars. In the US they call used cars of poor quality lemons, and nice ones, peaches.

Image for post
Image for post
Used cars of poor quality are called lemons in the US. Typically this refers to the fact that buyers can’t tell whether they are being offered a lemon or not.

Say a peach is worth 8 thousand and a lemon is worth half, 4 thousand.

Thus the average value of a car in such a market is 6 thousand.

If the owner of a peach offers it for 8 thousand, nobody will buy it, because buyers can’t know if it is a lemon or not.

They are more likely to pay the average value, which is 6 thousand. Lemon owners are more than willing to sell at this price, while peach owners will likely withdraw from the market.

Hence the market becomes dominated by poor quality. To sell in such a market encourages manipulative sellers. It is not without reason used car salesmen have such a bad reputation.

Real World Consequences of Information Asymmetry

The health care sector offers many examples of the problems of information asymmetry. In the market for health insurance, the person buying health insurance and the company selling it has vastly different information about the health of the person buying insurance. You know your own health better than a company.

As with cars this will tend to drive healthy people (the peaches) out of the health insurance market and encourage the unhealthy (lemons) to get insurance. The net effect is an increase in premiums, as insurance companies will not want to be stuck with high payouts to the high risk group. But this will just drive more people, of good health, out of the system.

To counter this, insurance companies engage in an elaborate bureaucracy to try to figure out the health risk of of a potential customer. They will create comprehensive questionnaires and crunch a lot of numbers.

This could get expensive. Even if this ended up being more expensive than the money saved, the prisoners dilemma would make it hard to stop this practice, as you risk the competing companies getting all the peaches, and your company all the lemons.

The problem of asymmetry continues at the point where a diagnosis has been made. Now the roles are swapped. The patient will lack knowledge to judge what is the most effective procedure to treat his/her condition. The hospital could offer a treatment which is optimal for the hospital, but not for the patient. The patient has no way of judging that, except in the most glaringly obvious cases.

Incomplete Information

Related to information asymmetry, are the cases where the participants in a market have poor information or knowledge about the quality of a service or product. For a market to work, consumers need to pick the cheapest and best products, rather than picking products arbitrarily.

A problem when people don’t understand a product is that they begin to focus on what can most easily be measured, even though that might not be very important with respect to quality.

Lets look at some examples from different markets how this plays out.

Digital Cameras and Mega Pixels

Most consumers don’t understand a lot of complicated products such as cameras and computers. The quality of these products is a result of a myriad of interacting factors.

The quality of a picture from a digital camera will depend on the quality and the size of lenses, sensitivity of image sensors, electronic noise filtration etc. Because this is too complicated for consumers, they ended up focusing on one simple, but fairly irrelevant metric: The mega pixel count of the camera sensor.

Image for post
Image for post
A CCD image sensor in a digital camera. People often focus on the mega pixel count of the sensor but the size and sensitivity of the sensor is usually more important.

All things being equal, increasing the number of mega pixels on sensor will reduce its light sensitivity, meaning you get worse pictures. So e.g. for most uses, 6 mega pixels would be more than enough. However people would still opt for 12 mega pixels and pay extra for that.

Computers and Clock Frequency

A similar situation happened with computers in the 90s. People struggled with deciding which PCs to buy. There were so many models with different specifications. So they settled on the comparing the clock frequency of the computer’s microprocessor. This is strongly related to the performance of a computer. However it is not the only relevant part. PC makers would then reduce the quality of all other components to fit a microprocessor with higher clock frequency in, despite the fact that it created an overall worse system at a higher price.

Image for post
Image for post
An intel microprocessor, which is what performs the calculations in a computer. Consumers in the 90s and early 2000s focused almost exclusively at the performance of this part of the computer at the detriment of everything else. In particular what we call the microprocessor clock frequency, which is related to microprocessor performance but which can be highly misleading.

The Effects of Using a Single Metric Over Time

Since car analogies are so popular I’ll try to compare this to cars. Focusing on mega pixels and microprocessor clock frequency is similar to buying a car almost exclusively based on the horse power of the car.

If you were looking for a high performance car, this might not be a bad metric, since horse power is often closely correlated with that. However a serious problem would develop over time if car makers learned that consumers made their purchase decision almost exclusively by looking at the measured horsepower of the car.

Image for post
Image for post
A Chevrolet Camaro with an oversized engine. It doesn’t necessarily make it a great racing car.

Normally a high horsepower car is balanced with other components. But if people stop looking at overall performance and only at the horsepower, then car makers will be incentivized to use cheap solutions on everything else. E.g. one could use heavier materials which are cheaper. A heavier car will have worse performance, but it won’t affect the horsepower rating.

One could put a huge engine in a car with poor aerodynamics and handling. That would limit its ability to perform on a realistic race track, and so on.

There is an important but subtle point here. Using data to make a decision such as horse power, is not the problem. Under normal circumstances it would be a good enough proxy. The problem is when everybody start making their decisions on one measure such as this, since it will cause the behavior of the car makers to change.

Education

How do you judge what is a good educational institution? It is an extremely difficult question to answer.

As with cameras or computers, people end up picking a few metrics which often have little to nothing to do with the quality of education, but which is fairly easy to observe or measure.

Sweden introduced a sort of voucher system for schools, so that parents could choose to pay a private school the same amount of money as a public school, for their child to go there instead. It led to a surge of private schools in Sweden.

Here we can observe many of these market failures. Many high schools e.g. started focusing on student laptops. It was something students could easily compare between schools and hence many ended up making school decisions with that as one of the main criteria. Obviously one of the least good metrics to measure school quality.

With private schools in general, ranking has been dominating. It has obvious problems. If one ranks schools based on results of students, it is impossible to distinguish between schools ranking high due to smart students and those ranking high due to superior teaching. The effects tend to compound itself as higher ranking schools will attract smarter students which will push up the ranking further. This will create a virtuous circle which has nothing to do with improvement in school performance.

Other alternatives are ranking based on research and papers published, but again that has little to do with the quality of teaching. Naturally it says something about potential however.

Final Remarks

While many markets work quite well, not all of them do. Especially markets such as health care and education don’t work well in a capitalist system. That is because the product they offer is not uniform and cannot easily be evaluated and understood. Everybody can easily take a few pictures with a camera to test it, or take a test drive with a car.

But you cannot walk into a single store and drive out being a student at 10 different educational institutions in the course of 2 hours. Nor can you go into a store an try out surgery from 10 different hospitals. And besides even if you actually could, the particular teacher or professor you got exposed to from a particular college, may not be the one you end up having. This is different form buying a car or camera. The camera you get in the box, will be almost indistinguishable from the one you tried in the store.

That is why often a market solution has to be improved through government regulation or even run as a government service.

Consider the case of health care. The goal of society is actually to cover all citizens. That health insurance companies then spend vast amounts of resources on a bureaucracy to rate the health and risk of insurance buyers is thus just a complete waste of resources. It is one of the reasons why e.g. American health care has some of the highest bureaucratic overheads in the world. While socialized medicine, despite mostly being run by government actually has significantly less bureacracy.

Written by

Geek dad, living in Oslo, Norway with passion for UX, Julia programming, science, teaching, reading and writing.

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store