Hayek conceived of a market economy as a sort of decentralized calculator. Participation by consumers and firms allows private information about technology and preferences to be communicated to the market which then summarizes the data in the form of prices. Transactions at these prices then allow goods and services to flow to their most efficient use.
Viewed from this perspective, information is a crucial input in an efficient allocation of resources. Asymmetric information is a friction on the system because it creates pockets of informational monopoly. Just as classical monopoly rents flow to an agent with exclusive ownership of a productive asset, when information is exclusive its holder can extract information rents from the market, typically by inefficiently distorting the terms of trade in her favor.
Alex Tabarrok and Tyler Cowen argue persuasively that advances in information technology are changing this equation. Let me discuss several caveats to their conclusions.
The End of Asymmetric Information?
There is no disputing the premise that technological advances are resulting in better information. But better information doesn’t imply more symmetric information. This is true even if the information is available to all parties. Consider genetic testing. A test that is highly predictive of a future disease creates symmetric information about health outcomes but at the same time probably creates asymmetric information about what really matters for market outcomes: the patient’s future health care costs. Indeed, health insurance companies will have exclusive access to a wealth of data that predicts the future costs of an applicant with a given array of genetic markers. Thus what would appear at first glance to level the informational playing field in fact will likely only shift information rents from patients to providers. There is no telling if this will lead to better or worse market outcomes overall.
The End of Market Failure?
There is however a far more sobering caveat to the apparent benefits of improved information technology. First, let’s remind ourselves why health insurance markets exist in the first place. Its not because we have any fundamental need or desire to accurately price health risk. A market price for risk is just one way of approaching the true fundamental objective of any insurance institution: to share risk.
Everybody has some chance of suffering an economic loss due to poor health or other risks. The uncertainty that creates is intrinsically undesirable. Insurance is how we smooth out those fluctuations. It involves transfers to those who suffer a loss from those who don’t. The feasibility of such transfers reduces risk and improves overall welfare for everyone.
Were we to actually see the end of asymmetric information then for sure the efficiency of markets for health insurance contracts will improve dramatically. With improved testing and symmetric information about the future health outcomes of the insured, contracts will be negotiated to reflect as accurately as possible the likely costs. Adverse selection will no longer be a source of market failure.
However, as a direct result of this, health insurance markets will cease to be a useful institution for actually providing insurance, i.e. sharing risk. That’s because every patient will be fully exposed to 100% of their health care risk in the form of the price they pay for their customized policy. This is called classification risk and there is a sort of conservation law that binds on any market-based insurance institution: you can eliminate classification risk, or you can eliminate adverse selection, but you can’t eliminate both.[i]
Markets for Information
Besides, information doesn’t come for free. It must be produced like any other good or service. If we expect dramatic changes in economic institutions due to the availability of information, then a lot is riding on the proper functioning of markets that incentivize its production. These markets are riddled with their own failures.
To begin with, information wants to be a public good (to correct a phrase). Like all public goods we can’t expect markets to provide the socially efficient amount of public information. But for information to be symmetric it must be public at least to some degree. To make profits, information providers will find a way to lessen the free-rider problem by selling exclusive access to information. In other words we should expect market incentives to frustrate rather than facilitate The Great Symmetrization.
Indeed the net effect of improved information technology could very well be more overall regulation rather than less once we account for all the new regulation of information markets that will be necessary to reap the benefits—and avoid the pitfalls—of improved information. To be convinced of this it’s enough to think of all the information-based regulation of lending markets intended to constrain lenders who are presumed to be using their informational advantage to prey on unsuspecting borrowers. Imagine those sentiments applied to futuristic insurance providers who have sequenced their clients’ genomes to forecast their health status.
To see the kinds of market failures caused by decentralized production of information look no further than the current hand-wringing over the “higher-education bubble.” Tremendous resources spent on providing a college education appear (to some) to be little more than a massive over-production of information (“signaling”) incentivized by market forces. Indeed as a general principle the mere availability of high-quality certification creates a kind of informational rat race which compels all suppliers to invest in certification. The overall welfare effects are ambiguous.[ii]
The End of Markets?
Fortunately we are in fact very far from the end of asymmetric information. But it’s a fun exercise to think about how we will know when we’ve truly reached that stage. Might I suggest that Hayek again has the answer? According to Hayek the superiority of a decentralized market economy – the main reason to live with all of the classical failures of market power, externalities, and public goods – is that it’s the most efficient system of collecting and aggregating asymmetric information.
So the way we’ll really know that the age of asymmetric information is over is that the age of markets will be over too. That’s probably a long way off.