Talking Past Each Other

(Also posted at The Voice)

While deep methodological differences exist across economists, many disagreements involve "talking past each other." Each side uses similar words to discuss fundamentally distinct, though related, concepts. This is especially a problem with every-day language words and leads to more confusion than understanding.

One problematic term is information. Everyone believes they have a reasonable definition and that others have the same concept in mind. This is unfortunate and stagnated the discussion. Only through clarity of thought and language can these issues be resolved.

Complete and Perfect Information, or Ignore for Now

Doing what was necessary for early models, the economists started easy. They ignored it. They approximated that every actor knows everything. That made life easy.

Since Marshall and Walras, economics focused on equilibria. Starting from perfect competition, complete and perfect information are crucial. How do supply and demand equilibrate? Everyone knows everything. After a few easy steps, boom, supply=demand.

While all economists admit perfect information is an untrue assumption, it is still the default in many models.

Information as Commodity Xn

Stigler believed that academics should understand that information is not free. Academics make their living by selling information.

And yet it occupies a slum dwelling in the town of economics. Mostly it is ignored: the best technology is assumed to be known; the relationship of commodities to consumer preferences is a datum.

Instead, information was mostly ignored until Hayek in 1937 and 1945. With his inspiration, economists tried to take information seriously. Information is not "given" to actors. It is an important part of economic activity and the market is an efficient means transmission.

George Stigler, in the "The Economics of Information", pushed Samuelsonian economists to study information.

For Stigler, information is another commodity. Its cost is a "search" cost. Buyers and sellers do not know all prices and preferences. Most goods have many different prices at different locations.  Each store visited to learn the price costs time and effort. Due to these search costs, we should not expect that sticker prices are uniform across a market. It costs buyers and sellers to arbitrage these differences away.

This leads to the realization that like any other commodity, there is an ideal amount of information. It is the point where the marginal search cost equals the expected marginal benefit in reduced price. Actors may not have prefect information, but they are rationally ignorant.

In Stigler, this ignorance is symmetric. Neither buyers nor sellers know the differences exist. The equilibrium will not result in marginal cost = marginal price = marginal value, but it will arrive at a close approximation to that, with information costs as the "error" term.

Asymmetric Information

In the 1970's, Stigler's model was greatly expanded to include asymmetries. George AkerlofMichael Spence, and Joseph Stiglitz are the godfathers of this field and together won the Nobel Prize in 2001 for their "analyses of markets with asymmetric information."

Though everyone is still rationally ignorant, not everyone has the same costs of information and this asymmetry can change the equilibrium of markets. There is an inefficiency in the market since mutually beneficial trades do not take place. One party does not know that the trade is beneficial. Adverse selection, morale hazard and moral hazard become problems that lead to screening and signaling as remedies. Earlier models ignored these costs, which often produced different conclusions.

While some of the conclusions are different between asymmetric and imperfect information, they are models within the same framework. Costs of information change the equilibrium. This framework leads to powerful conclusions. It is understandable why economists use it. As I've said in other posts, it is really hard to find any problem with a model, using that model.

Information and the Market Process

However, some economists were not convinced and developed a different model with a fundamentally different understanding of information.

This part of economics was also inspired by Hayek, but read him differently. To them, Hayek was not arguing simply that the market is a cost-effective way to send information. Instead, the process of buying/selling/transacting/cooperating within a market system generates new information that would not otherwise exist.

It is not that the information was very costly and now, because of the market process, it is cheaper so actors buy it. The supply/cost curve of information does not suddenly shift. Instead, the curves are first created through the process.

Where to Go?

Integrating these two "types" of information into models would benefit economics. This is not easy. If I could do it, it would be in the AER, not on a blog. Yet, difficult does not mean impossible or unimportant.

Either someone develops a theory that includes both concepts adequately and concisely to distinguish between the two types (such as Frank Knight roughly did with the ideas of uncertainty and risk) or we will continue to talk past each other.

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