Imperfect information is a situation that occurs when either one or both parts of a transaction in the economy are not completely aware of all the features and qualities of the product they are selling or buying The frequent and extensive existence of imperfect information can be a reason for the market failure that leads to a substantial welfare loss Nonetheless there are various ways in which the government can prevent the economy from the Pareto inefficient situation In a perfect economy both producers and consumers are supposed to have the excellent knowledge of the market That includes the prices costs ingredients when it comes to specific products and other components that should be taken into account while executing a transaction from one party to another However that point of view is rather unrealistic as the information between the buyer and seller is hardly ever absolute In most cases the transactions are being processed under asymmetric information which means that where people involved have an unequal amount of knowledge about the aspects of what is being sold or bought some know more than the other The first form of asymmetric information known as a problem of hidden action exists when somebody gets involved in a risky event bearing in mind the fact that he or she is under protection against the risk and the other party will incur the cost A great evidence of how this situation may result in a market failure is provided by Michael Lewis 2010 in his book about the financial crisis caused by the United States housing bubble based on true events that took place during the 2000s In this case there was no partition separating investment banking and commercial banking which allowed previously stable traditional banks to invest in a nefarious mix of low grade high yield investments The contributors were not perfectly aware of the risks introduced into the system by the banks perhaps because many were international
That allowed American investment banks to foist off numerous high-risk pools of investments for liquidity developing a stupendous bubble in the United States housing market If there is one general statement to be made from this debacle it is that the problem of moral hazard can result in dreadful consequences on the largest scale possible and moreover wherever moral hazard occurs deceit tends to happen The example of Lemons given by George Akerlof 1970 in his Nobel prize winning paper demonstrates what are the effects of asymmetric information in this particular case The customers doubting the credibility of the owners of good and pricier cars had an incentive to purchase the less expensive ones That situation kept happening and cause the best vehicles to be outrun by the bad or average quality cars As a result buyers started to lower their expectations for any given car meaning that the average willingness to pay decreased Those circumstances would encourage the owner of good cars not to sell and leave the market which eventually would lead to a market failure This instance is an example of hidden attributes the problem that occurs when some characteristic of the person involved in an exchange is not known to other parties
As a repercussion of the aforementioned mechanism markets might completely fail to prevail The existence of imperfect information can be the reason for both buyers and sellers to refrain from taking an interest in the market Consumers might become discouraged because they cannot determine exactly the condition of a product Sellers on the other hand might be hesitant to take part because it is difficult to prove the quality of their goods to buyers and since consumers cannot determine which products have higher quality as many times a buyer confronted with imperfect information will tend to believe that the price declares something about the quality of the product they are unlikely to be willing to pay a higher price for such goods When imperfect information is earnest markets may become terribly thin since a comparatively very small number of participants attempt to exchange enough information that they can agree on a cost Even if the sellers establish the price accordingly to the quality of a product the consumers still keeping in mind the existence of imperfect information may doubt its credibility Therefore the low cost might not be attractive to more buyers Contrarily a producer who increases prices may come across a greater success as the buyers might associate the bigger cost with a higher quality This situation demonstrates how the issue of imperfect information can affect consumers decisions despite the sellers rational behaviour In brief the lack of complete symmetric knowledge accompanying the transactions taking place in the economy results in the marginal social benefit being unequal to the marginal social cost in other words leads to a disequilibrium The aforementioned situations of either undervaluation or overvaluation of a product are demonstrated by the following graphs
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