A well functioning market needs information. The definition of a perfectly free market includes the assumption that there is ‘perfect knowledge’.

In order for the market to work, buyers must know what the price of a product from a particular firm is, and what the prices are at all the other firms too. This way the customers can decide where to shop. Not only must there be knowledge of prices by customers, all the firms need to know what their competitors are charging. Producers also need price information, and they must all know what the costs of production are for the other firms. So if one firm is buying raw materials cheaper, the other firms know and can make use of this information to lower their own costs. Remember prices act as signals in free markets and we need to see them.

Persuasive advertising

A perfectly competitive market has a homogenous product. Homogenous means ‘exactly the same’, and in a competitive market products will be very much alike if not homogenous. Persuasive advertising seeks to differentiate a product making it seem something more than it is. Advertising that tells customers where they can buy the product, how much the price is and gives technical information is a good thing. This is called informative advertising. However advertising that tries to entice or persuade is not providing information, it is trying to make you want something that you did not want beforehand. Persuasive advertising adds to costs as well as trying to make customers believe a product from one firm is better than similar products from other firms. Another problem is that firms may deliberately make information so complex that consumers cannot make sense of it. How much does it cost to boil a kettle or make a phone? Electric, gas and mobile phone companies have all been accused of making their tariffs so complicated that no-one can calculate the prices. This confusion makes the products offered less than perfect substitutes for each other, and therefore the demand is more price inelastic, and prices are higher than they would be if consumers could compare products effectively.

Asymmetric information.
In 2001 George Ackerlof was awarded a Nobel Prize in economics for his insight into markets. His work demonstrates the role information plays in market economies. Ackerloff shows what happens when people do not have the same information. In some markets the problem is worse than others. Ackerlof used the market for second hand cars to make his point.

If I want to sell my four-year-old Mini-Cooper I would like a decent price for it. I drove it carefully, washed it and cared for it. Every year it has a service from the official BMW approved dealer and it has never broken down.

However, if you are looking to buy a Mini-Cooper you do not know this and even if I told you, you might think I am lying. In short I have more knowledge about the car than you do. This is what is meant by the term asymmetric information.

In the market for second-hand cars we will assume there are two types of cars — good cars with few problems that we will call plums, and poor cars with a lot of problems — or lemons as they are know in the USA.

First we have to imagine a world where there is no information available to buyers. If they believe that half the cars are lemons and half plums, and that they would pay £1,000 for a lemon and £5000 for a plum they might make the following calculation to work out an average price, (0.5 x 1,000) + (0.5 x 5,000) = £3,000.

Plum or lemon

However the sellers of cars know a lot of information because they have been driving them for a while. The owner of a lemon would be delighted to get rid of their car for £3,000 but the owner of a plum worth £5,000 would not. The only cars on the market would therefore be lemons and the market for good second hand cars would disappear.

In the real world we can get around the problem. The government in the UK requires a certificate of roadworthiness called a MOT test. This ensures the car is safe to drive. In addition manufactures sell cars with log-books so that owners can get official stamps from car dealers to certify that the car has been regularly serviced. Second hand car dealers usually let you take a test drive too. Furthermore each car comes with a odometer that records how far the car has been driven. It is against the law to interfere with the odometer and there are heavy fines and even jail sentences for doing so. All of these measures provide information to the buyer. The Automobile Association will also carry out a vehicle check for a small fee and advise you on the condition of the car.

What Ackerlof has been awarded a Nobel Prize for is demonstrating the role that information plays in free markets. His insight casts light on a number of other problems.

Alcohol, drugs and tobacco
In the UK there are rising number of hospital admissions for young people suffering from alcohol related diseases. The benefits of drinking are immediate but the costs are not suffered until years later. There is a lack of awareness of the true long term benefits and costs of substance abuse.

In a world of asymmetric information with regard to people’s health, the market for sickness and travel insurance would be a lot smaller than it is now. This is a similar problem to the second-hand car market, and is termed the problem of adverse selection. Only sick people would buy insurance and then insurance companies would end up paying out frequently and go bankrupt.

If people who had good health obtained insurance, then companies wouldn’t have to pay out very often to this group. But if there was a single premium charged to their customers, this price would need to cover the costs of meeting the claims of both healthy people and less healthy people. The premium would have to be high, but at this price the healthy would think it was not worth paying. Premiums for the less healthy would then have to rise even further. In the end there would be no insurance market for people who were usually healthy.

Just like the market for second-hand cars there is a way round the problem. Insurance companies can ask for your medical details and adjust the premium (price) accordingly. The insurance companies make sure you are telling the truth by refusing to pay out if they discover people lying on their application forms. This is an attempt to avoid the problems of moral hazard. Insured people have paid a premium, and when something goes wrong they make a claim which the insurance company pays. The insurance company has less information about the problem than the claimant. This encourages the insured people to make false or exaggerated claims.

A further moral hazard is that the insured feel safer and tend to behave more recklessly. Thus insurance can bring about bad behaviour. Recently economists have claimed there is a moral hazard in bailing out bankrupt banks. Saving financial institutions like the Royal Bank of Scotland from insolvency encourages other bank directors to take on risks knowing they are safe when their decisions turn out badly.

Employers might be faced with a large number of applicants for a job. How can they choose? What the employer wants is someone who is capable and works hard. An interview gives some information but obviously people may lie. Application letters and references also help, but again the information is not necessarily reliable.

This is where we can see the importance of qualifications. A degree from a good university such as Oxford or Cambridge, even for a degree in archaeology, tells an employer that the candidate is of a certain standard. The employer knows Oxford and Cambridge are hard to get in and that a degree takes three years of effort. So the holders of Oxbridge degrees are known to be capable and hard workers. The degree subject is of less importance.

If there is a lack of information about employees then employers could try and solve the problem another way. If they offered a wage above the market rate, then this would attract hard and capable workers to apply, and those selected would to try and keep their jobs by working hard. Even a lazy worker would have an incentive to work hard because if they lost heir job, the next best alternative job would pay much less. However, paying above the market rate wouldn't just attract people who previously didn’t want to work, the employer's quantity demanded would contract. The result would be an increase in classical unemployment. That is there would be fewer jobs available than there were those willing to do them.


Asymmetric information
Where one party in a transaction has more or better information than the other.

Adverse selection
A situation of market failure caused where buyers and sellers have asymmetric information, and the poor quality products (or customers) drive out the good.

Classical unemployment
Unemployment that results from real wages being above their market clearing level and causing an excess supply of labour

Informative advertising
Advertising that provides customers with information about the price, product and where to buy it but does not appeal to emotions.

Moral hazard
Any situation in which one person (the agent) makes the decision about how much risk to take, while someone else (the principal) bears the cost if things go badly.

Persuasive advertising
Advertising that seeks to differentiate the product or service from other products and make the demand for it more price inelastic, often by appealing to emotions.


Powerpoint presentation to accompany this page can be found here (Merit goods and demerit goods/Imperfect information) Teachers might wish to use this Powerpoint and use the pdf file as a handout for students.

pdf file of this page

see George Akerlof's Nobel Prize acceptance speech explaining the 'Market for Lemons