The ‘Information Asymmetry’ Paradigm is Vacuous

November 16th, 2014
in macroeconomics

Fixing the Economists Article of the Week

by Philip Pilkington

Sympathetic Post-Keynesian types often ask me what I think of the whole ‘asymmetric information’ paradigm. They’re often struck when I say that I think that its vacuous. After all doesn’t this paradigm undermine the dreaded General Equilibrium theory? Well yes it does but that doesn’t mean that it is in any way substantive. You can’t just lend a paradigm credence because it produces results that overlap with your own.

Follow up:

In his book Minding the Markets — about which I will be writing more posts on in the coming days — David Tuckett provides a very nice summary of George Akerflof’s famous ‘market for lemons’ paper. I actually did this in my masters degree — marginalist microeconomists love this paper because of its Sudoku-puzzle qualities — but I never wanted to write about it because I didn’t want to bother summarising it. Tuckett has done me a great service in this regard. He writes:

Akerlof supposed that in the secondhand car market well- informed sellers face ignorant buyers and that there were two kinds of car – reliable cars and lemons. The seller knows which he thinks he has but it is difficult for the buyer to tell. His formal analysis showed how the price of used cars will be discounted to reflect the incidence of lemons in the population. It will be an average of the values of good cars and lemons. But that average is a good price for the owner of a lemon, but a disappointing price for the seller of a reliable car. So owners of lemons will want to sell and owners of reliable cars will not. As buyers discover this, that knowledge will pull down the price of secondhand cars. And things will get worse. The lower the average price, the more reluctant the owners of more reliable cars will be to sell and the more suspicious buyers will get, driving things down further. The end result will be that secondhand cars will be of poor quality and many secondhand cars will be bad buys even at low prices. (p5)

That’s basically it. That is pretty much what all the fuss is about. The student is then taught to work this out carefully in some sort of tedious problem set form. The exercise shows that within the given assumptions the market breaks down pretty much completely. Akerlof provisionally reaches pretty absurd conclusions when he writes:

The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.

Really? People being dishonest in a market drive honest people out of this market? Really? Does the author genuinely think that this is a description of the real world? Well, in the real world there are many car dealers that sell junk and yet, for some bizarre reason, the market continues to exist.

So, why then doesn’t the market break down? Well, anyone who has ever dealt in second-hand cars — I used to buy and sell them when I was a teenager — knows that this is all a question of trust. You must convince the customers that the car is not a lemon. You must provide papers documenting the car’s service history and so forth. Maybe they will even hire a mechanic to test the car. Basically, the seller who has limited information tries to gain more information. (Actually, in my experience the seller often doesn’t have full information about the car either if they are a dealer/arbitrager, but I digress…).

Alternatively, the dealer could just try to talk the customer into buying a piece of crap. This happens too, so it can’t be ruled out. But it sure as hell doesn’t lead to the market imploding. Anyway, leaving this aside, Akerlof basically notes this. Tuckett points this out when he writes:

Since we have markets, the conclusion highlights how building trust must be a crucial element in the way financial markets work and demonstrates how parsimonious abstract modelling can very efficiently and rigorously get to the heart of a matter. Buyers can only be persuaded to trust sellers and so come into the market if the underlying situation of information asymmetry is somehow modified. One way is for sellers to try to frame the information context in which decisions are made to make the buyer more confident in the seller – for example, by advertising ‘one owner’ or ‘lady driver’, by offering to show service records or a report from an independent agency, or by taking explicit measures to share the risk of things going wrong in future, such as a guarantee from a reputable source. Some of these devices are discussed in Akerlof’s original paper. (pp5-6)

Okay great. So why do I say that this is vacuous? Well, think about how this argument is fobbed off on the student. First, the student is told to assume perfect information. They are told to think about a very abstract model in which everyone knows everything and prices reflect this perfectly. When the critical student says that they do not believe how this is real markets work they are told to shut up and do their problem set. When they bring up anecdotal evidence that markets work completely differently and have much to do with power-relations, emotions and trust they are again told to shut up.

So, the student either shuts up or they migrate to a more realistic discipline. If they shut up for long enough they eventually move on to intermediate microeconomics. Now they are told to take on board a few instances in which issues such as trust arise. They are then showed how this undermines the perfect information model that they spent a number of years working their asses off to master. Now they are told that these more psychological or sociological aspects of markets need to be studied.

Well then what the hell was the point of studying the perfect markets stuff in the first place!? Any reasonably bright 18 year old can see that markets are predominantly determined by issues of power, emotion and trust. So, why didn’t we just run with it in the first place?

All Akerlof’s model shows is that if you don’t assume perfect information but you do assume some vague notion of rationality the market will break down. Then he provides a few hand-waves as to what actually stabilises markets — which are the very factors that students are told not to think about when they start studying markets! Students are basically led around on a wild goose chase and come out the other side with a bunch of tools that are altogether useless for studying real world markets.

The end result is that the students will try to model these issues of power/emotion/trust using the very same tools that were only really appropriate for the perfect information, perfect rationality assumptions. There’s a term for this in the philosophy of science: its called a ‘degenerating research program’. A research program is degenerative when ad hoc additions are made not to produce novel facts but to defend core assumptions. In this case the core assumptions are those of rationality and market-clearing prices and so forth, while the ad hoc assumptions are handwaves toward issues of trust and so forth that cannot really be studied using the tools that practitioners spend years of their lives acquiring.

A progressive research program would start from the assumption that issues like trust, emotions and power play a fundamental role and would then build on this. So, for example, a progressive researcher might look into existing literature on the psychology and sociology of trust and then try to integrate this with basic economic insights about markets in the study of any particular markets which they would approach not deductively but empirically. This is, in fact, what Tuckett is doing in the book but I will leave this for another day. For now it should just be made clear that at best the asymmetric information paradigm is a degenerating research program, at worst it is a vacuous waste of time and money which is turning out useless economic students that spend their whole time chasing their own tails and have no capacity to actually study interesting multidisciplinary approaches to microeconomics.

Finally, a note on intent. Akerlof warmly received Tuckett’s book and gave it the highest of praise. But Tuckett is completely shunning the core assumptions of marginalist microeconomics. Are we then to assume that Akerlof’s intent in his famous paper was wholly destructive? Should we infer that the idea was to tear down the General Equilibrium edifice so that people could take more realistic approaches? I am certainly willing to entertain the possibility. But this is not what happens. Rather students continue to chase wild geese and learn mathematical tools that are completely inappropriate for dealing with the problems they are studying. They then try to apply these tools to the material and they end up with theories that are just as arcane and irrelevant to the real world as are the old perfect information General Equilibrium models. If you want to tear up the old paradigm you have to do so at the roots. Attacking the branches does nothing at all. In fact, it strengthens it.

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