Knowledge and preferences are asymmetrical and exist in a dispersed pattern within billions of individual minds; this is a basic fact of life. Therefore, the total knowledge and absolute preference of an entire society cannot be known within a single mind. This total knowledge and general will is revealed through the process of free exchange, the price system, and voluntary interaction in the marketplace.
Many mainstream economists—such as 2001 Nobel Prize winner Joseph Stiglitz of Columbia University, and 2017 Nobel Prize winner Richard Thaler of The University of Chicago—have suggested that this problem of what they call asymmetrical information, i.e, when either the consumer or producer has more information about any given transaction than the other, allows producers to easily swindle consumers and is a market failure which requires government intervention. While it seems almost impossible to coordinate this dispersed knowledge under conditions of such massive ignorance, the complex spontaneous system of incentives which make up the invisible hand are able to do so.
Before this claim is refuted, it is essential to note that “asymmetrical information” is essentially a synonym for “the division of knowledge (and labor) in society.”
Most market solutions to asymmetrical information problems are solved through one of three methods: a third party/information middleman, a review system establishing some sort of credibility for either the producer or consumer, or a system of product warranties that enable the buyer to return the product over a period of time for his or her money back/replacement at no extra cost to the buyer.
Suppose you want to go buy a good used car on Craigslist, however, there is a problem: half of these used cars are lemons—cars which will be nothing but expensive problems for you. Each seller knows he or she has a lemon (and won’t tell you so); you are not sure which cars are lemons and which are not. You value a good used car at $5000, and the seller is willing to sell a good used car for $4000. A lemon, lets assume, is worthless.
Since 50% of the used cars are lemons, and you value a good used car at $5000, you are therefore only willing to pay $2500 for what may or may not be a lemon. Since the used car vendor wants $4000 for the car, the costs will outweigh the benefits for most people. The used car market would be dominated by low quality cars and eventually fail altogether: and you still might pay $2500 for a lemon. However, the free market has multiple solutions: a third party sets up a satisfaction guaranteed used car dealership which has proved to be legitimate. Another solution is where someone sets up a website where people can write reviews on their experiences at different used car dealerships. Also, since a car is an experience good, the seller could create a warranty system to enable the buyer to return the car for his or her money back during a certain period of time.
Another example of asymmetrical information is banking. The bank does not know if the person who they are loaning money to will repay their loan, and the person putting money in a fractional reserve bank does not know if they will get their money back. The government has instituted the FDIC instead of allowing the market to coordinate this information on its own. A possible market solution is to have third party privately run bank insurance companies who do what the FDIC does but privately. Also the review system of a credit score allows banks to get a pretty good idea of whether people are likely to repay their loans.
The ground beef market is another good example of an asymmetrical information problem. Since there is a semi-decent probability of a ground beef patty being infected with a disease, consumers do not know which beef to trust. Imagine you value a good pack of ground beef patties at $12 and they are being sold for $10. There is a 20% chance that the patties are infected with E. coli. With these odds, you are only willing to pay about $9.50 for what may or may not infect you. This would put the quality beef vendors out of business and you still might be paying $9.50 for some poison beef. The government has instituted the FDA instead of allowing free markets to develop their own solution. A possible market solution is a trusted third party such as Whole Foods or Albertsons who take extra care to assemble trustworthy beef and then resell it to consumers.
The labor market for women is another example. Companies do not know if a woman they hire will get pregnant soon and have to take time off on maternity leave. Imagine a company values a normal worker at $1200 per month and someone is willing to work for $1000 per month. Assume that there is a 33% chance that the worker is a woman who will get pregnant and take a maternity leave and cost a company more money. Because of the odds, a woman is now worth only about $800 per month which she is not willing to work for. This will force women to work for less money and the company still might lose money. Although it is illegal to mention pregnancy in a work contract, markets and incentives cause companies to find other ways to deal with (and spread out the costs of) the possibility of a surprise pregnancy. For example, a company might give an employee a starting salary and promise to give them a raise if they don’t take time off for their first three years of work, incentivizing women to not take time off for maternity leave. Also the companies could use incentives to encourage harder and more productive work during the time people are at work to make up for taking time off.
Yet another example of asymmetrical information is the health care market. Patients (consumers) do not know if the doctor they are going to see is a legitimate doctor. Imagine a patient values a trip to the doctor’s office at $1000 and a doctor’s appointment costs $950. There is a 10% chance the doctor is fake and will accidentally kill you. Logically, the patient will only be willing to pay $900 for these odds which a real doctor is not willing to work for. This will put the legitimate doctors out of business and patients still might pay $900 to die. While the American healthcare system is far from a free market, and occupational licensing has been instituted in place of a market, there are still real market solutions to this asymmetrical information problem. An example is to have a trusted private hospital or clinic who assembles a large amount of trusted real doctors and acts as an informational middleman between doctor and patient. Also, someone could set up a website where people write reviews about experiences with their doctors to help real doctors develop credibility while weeding out the doctors with dubious training.
The most amazing thing about these examples and the way in which the invisible hand coordinates asymmetrical information is that individuals are driven to serve others through their own self interest, rather than through altruism.While there will always be people who dishonestly attempt to obtain what others have, free markets systemically reduce this type of fraudulent behavior and, and generate more honest and properly informed human interaction. As Adam Smith famously explained, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.” In this statement he truly captures the beauty of a free society governed by free markets. By living according to one’s own preferences and values, society benefits as a whole from the creation not only of wealth, but of beauty.
In his book, The Fatal Conceit, F.A. Hayek states that, “The curious task of economics is to demonstrate to men how little they know about what they imagine they can design.” In addition to misallocating of resources, government intervention solves these asymmetrical information problems far less efficiently than do private individuals operating based on a system of incentives. In the marketplace, a frustrated consumer can immediately stop doing business with a supplier who they believe has been dishonest or untrustworthy, forcing the supplier to suffer for his or her poor service. This is not so in the political arena. If a voter feels that a politician or his bureaucrats have been dishonest or inefficient, he must continue to fund their activities as well as obey the rules and regulations they have imposed on him. If the voter fails to comply, he pays with his life.
The claim that a board of central planners can some how coordinate this infinitely complex, dispersed, asymmetrical knowledge and information is the fatal conceit to which Hayek is referring. When allowed to work, the invisible hand does a far better job than any central planner or social engineer could at delivering goods and services to the people and places who need them most.
Lastly it should be pointed out that the reality of dispersed knowledge and asymmetrical information in society should be celebrated and cherished. This beautiful lack of symmetry is what gives humans their individuality and creative spirit. If we all had symmetrical information about the above tasks, it is safe to say that none of the above mentioned businesses and occupations would exist. It is neither possible nor desirable for symmetrical information to exist. Hence, the real lemon in this problem is the claim of a market failure.