Dialogue and policy design amid information asymmetry

NEW DELHI: We cannot solve our problems with the same thinking we used when we created them, noted Einstein. When it comes to fresh thinking in the realm of public policy, the insight provided by the new economics of information has meant a “paradigm shift.” Factoring in “asymmetries of information” among market participants, it has been shown that the “many and sometimes subtle ways” in which markets can fail to lead to efficient outcomes.

By dropping the assumption of perfect information in transactions and exchange, we can better explain such real world phenomena as dysfunctional institutions, bankruptcy and innovation, or rather the lack of it. And so proactively follow through say with incentive contracts, proper risk management and regular disclosure.

A recent policy research working paper is on the economics of imperfect information, in particular the work of Stiglitz, a pioneer in the field. It’s notable because when the convenient premise of perfect information is done away with, many of the implications of “standard” theory turn positively weak, or simply lose validity. The new insight has also meant better theoretical understanding of the mechanics of the “economic system as a whole.”

Now a “critical assumption” of standard reasoning is that there is a price for each quality of good in the market, and also for each action one would wish to contract for. In such a scenario, buyers have no problem ascertaining quality; firms adhere to quality as a matter of course; companies do not need to motivate their staff; lenders do not worry about borrowers repaying; shareholders do not worry about managers taking the right actions, and so on and so forth.

But in the real world, such presumptions may not hold, on their own. It is be-cause of the importance of incentive problems and the role of non-price institutions (for example, banking) within the economy, that the glaring inefficiencies and shortcomings of socialism were no historical accidents.

Rather, the bundle of contradictions were the inevitable consequence of (a) the limitations of information contained in repressed prices, and (b) the gap between the set of goods for which markets can artificially exist and the much broader set of present and future goods required for economic welfare. In everyday markets, the exchange problem is complicated with the process of selection over hidden characteristics, the provision of incentives for latent behaviours and the co-ordination of choices over various institutions.

It follows that “equilibrium” outcomes in the midst of imperfect information and missing markets may not quite be “efficient” and smoothly functional. Hence the need for proactive government intervention in the form of tax design and other incentives to have more beneficial market outcomes on the ground.

Consider, for instance, the problem involved in the design of an optimal tax schedule. Governments may keep tab of incomes of individuals, but not their ability and effort. Given this “asymmetry of information,” the logical way ahead is to distribute a given tax burden according to differences in ability to pay. Stiglitz put two and two together and noticed the similarities between the fiscal problem and the problems that arise in markets with asymmetric information.

Insurance companies and banks, for example, want to have a whole list of product offerings that will boost their returns. But they do not know each individual's risk of accident or bankruptcy etc. and the care that a person takes to avoid mishap. Similarly, employers want to design labour contracts to step up productivity, but they can only imperfectly observe ability and effort.

There can be umpteen such instances. Along with a small group of pioneers in the 1970s, Stiglitz devised models in which such kinds of problems could be best analysed. The work on hidden characteristics (adverse selection) and incentive problems (moral hazard) have came to be the “core” of the economics of information. The reasoning has led to a fundamental result in finance.

Now the efficient markets theory postulates that the observation of prices in capital markets “suffice” to reveal all relevant private information. It has since been shown to be incorrect.

If information is costly and markets are competitive, then there are more likely to be “persistent discrepancies” between prices and “fundamentals.” When investors “invest” in information and find for themselves that the return to a security is going to be high (or low), they bid its price up (or down), and thus the price system makes that information publicly available. But differential information can be a source of pure economic rents.

High “search costs” and other rigidities can make the price system wonky. The bottom line is that the economic theory of information “established that neither markets nor governments work perfectly.” It has, since the 1990s, contributed to the resurgence of empirical work in economics.

(Policy Research Working Paper 4478, The World Bank, January 2008)