A Note on Economic Theorizing and “Imperfect” Information

by Don Boudreaux on April 14, 2014

in Economics, Reality Is Not Optional

Warning: Wonky

Gregory Griffin e-mailed to ask me to elaborate on the significance of today’s Quotation of the Day.  This quotation is the one in which George Stigler criticizes economists who (I now paraphrase Stigler) regard markets in which traders are not fully informed as being “imperfect.”  Stigler’s point is that economists should treat information no differently than they treat every other scarce good or service – namely, as a valuable item that is possible to acquire in economically excessive amounts.  At some point, the value (although positive) of additional information is less than is the (also positive) cost of acquiring that additional information.

(There are some trenchant Austrian glosses upon this insight.  Information and knowledge are indeed economically unique in some ways.  Yet the elementary truth and importance of the insight conveyed here by Stigler stand, despite being ignored by too many economists.)

Words and labels matter.  When used carelessly, words and labels can mislead.  Economists routinely build models of markets in which people are assumed to have perfect information (which is to say, models in which all potentially relevant information is acquired costlessly by all people ‘acting’ in the models).  Such ‘perfect-information’ models yield certain predictions about how markets operate and of what the results of those operations will be.  Not surprisingly, these predictions are generally quite agreeable – that is, they satisfy our instincts about what good market operations and outcomes ought to be.

With perfect information, no one gets fooled; no one errs; no one takes unjustified advantage of anyone else; no one fails to seize the most valuable opportunities available to him or her.  The outcomes of perfect-information markets generally seem to be, not surprisingly, ideal or perfect.  Prices are always ‘right.’  No one ever suffers any inconvenience, loss, or other ill consequence of being less than fully (“perfectly”) informed.

But to call such outcomes “perfect” strongly suggests that different, less-ideal outcomes are “imperfect.”  The impression conveyed by such language and theorizing is that the lack of perfect information causes markets to fail in some ways – to come up short – to not perform as well-functioning markets ‘should’ perform (or can, perhaps, perform if only the “imperfection” is gotten rid of).  It’s a short leap for many theorists from this conclusion to the belief that government should do one of three things: (1) intervene in the market to force the market outcomes to be more like what the theorists theorize the outcomes would have been if information were perfect; (2) intervene to encourage or enable market participants to gather more information; or (3) replace these imperfect markets with government-run enterprises or agencies that – because of the “Then a miracle occurs” step – are simply assumed to be able to outperform markets.

Without here denying the theoretical (or even practical) possibility that any one or more of these kinds of government interventions into the economy can make people generally better off, enthusiasm for such interventions is fueled too quickly, too strongly, too voluminously, and mindlessly by the mistaken impression conveyed by talk of “imperfect markets” and “imperfect information.”  In fact, markets that economize on information are no more imperfect than are markets that economize on lumber or lightbulbs.

Market outcomes certainly would be different and better if, say, lumber were free.  More products would be made of wood, and we’d have larger supplies of products made with wood.  The prices of products made with wood – and the prices of non-wood products that compete with wood products – would all be lower.  If lumber were free, we’d all be richer.  Yet no one argues that markets are imperfect because lumber is not free.  No one judges that markets fail because people do not grow, harvest, and use all of the lumber that is physically possible to grow, harvest, and use.  No one suggests that the market’s “failure” to use lumber as if it were free creates a prima facie case for government intervention into markets.  Information should be treated similarly.

Indeed, markets are correctly recognized as being quite effective at economizing efficiently on scarce goods such as lumber.  If the supply of lumber falls, the price of lumber rises and people use plastic and other substitutes for lumber more intensely.  If the price of lumber rises, entrepreneurs are inspired to plant more trees or otherwise invest in ways to increase the supply of lumber.  Economists recognize these responses and applaud them.  Economists should, I think, be more attuned to ways that markets not only economize on information (including by finding ways to make its absence less troublesome) but also inspire and incent entrepreneurial efforts to increase supplies of useful information.

The absence of perfect information is indeed unfortunate – just as the absence of unlimited supplies of lumber or of lightbulbs or of cancer-curing pills is unfortunate.  We do not dwell in Eden.  But the absence of information does not render markets “imperfect,” and economists shouldn’t be so quick to assume that if the information possessed in markets by market participants isn’t perfect, then those markets are “failing” or are appropriate candidates for “correction” by government.

I close this wonky post with a quotation from Armen Alchian.  In footnote 5 of his brilliant 1969 Western Economic Journal article, “Information Costs, Pricing and Resource Unemployment” Alchian wrote (original emphasis):

A “perfect” market would imply a “perfect” world in which all costs of production, even of “exchanges,” were zero.  It is curious that while we economists never formalize our analysis on the basis of an analytical ideal of a perfect world (in the sense of costless production), we have postulated costless information as a formal ideal for analysis.  Why?

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