Economics Analysis/ Essay / Paper by

Economics Analysis/ Essay / Paper by



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  • 1. 1 Economics Analysis This paper is based upon the discussion of economics of information in the book by Levitt and Dubner “Freakonomics”. The authors offer an example of a market that is dominated by imperfect information – the term life insurance market – and relate this example to factors that impact decision-making under uncertainty. Before proceeding with the discussion of the case discussed in the book, it is useful to provide the definition of imperfect information and other related microeconomic analysis concepts. Imperfect information is an example of market failure to allocate resources efficiently. Neoclassic economic theory assumes that free market is a perfect tool for achieving allocation efficiency; thus, under the free market system rational consumers will possess full information on the goods and services available to them and producers would have access to all resources and production factors. However, in reality markets fail to be efficient. Other examples of market failures include positive and negative externalities (effects that occur in third markets and result from transactions that happen in a particular market; examples include pollution), public and quasi-public goods that have to be provided by the government since it is ineffective for private agents to serve those goods to the market due to the fact that providing such goods would result in loss of profitability, market power (monopoly domination of the market), and fairness issues (the market does not hold that some individuals are poor or require social assistance). Imperfect information (or missing information or asymmetric information) is a situation when market agents (consumers, producers, and the government) fail to make presumably rational choices (based upon benefit maximization and cost minimization) due to lack of information (or when it is inaccurate, incomplete or uncertain). Imperfect information can be
  • 2. 2 attributed to misunderstanding the costs of production (by manufacturers) or the benefits that the product offers (by customers), uncertainty concerning costs and benefits (in case of public and quasi-public goods), complexity of information (discussed by Malcolm Gladwell in his book “The Tipping Point”, where he pointed out the people who know everything about a particular market; calling them market gurus, he suggested that those people serve well to remove the complexity of information in such markets as automobile market or computer market (Gladwell, 2000)), inaccurate information, and addiction (in case of drug addiction, abusers may find it difficult to prevent themselves from consuming harmful substances). A particular case of interest is the situation of asymmetric information. Asymmetric information occurs when a market agent engages in buying or selling a product while possessing more information about it than the counterparty of the transaction. Asymmetric information was discussed by Akerlof in his article “The market for lemons”. In this article, the author discussed two types of used cars: the ones that are fair and not-so-well (or lemons, as most economists call such vehicles). Since the consumers do not know, which car is which, the situation resolves to owners of good vehicles being paid nearly the same as the owners of lemons, while in reality the owners of good vehicles would not want to strike a deal on the amount that lemon owners want for their cars. Since buyers cannot note the difference in quality, the market for used cars equilibrates at an average price of a good vehicle and a lemon (Akerlof, 1970). Other markets such as banking services market, share market, labor market and insurance market are good examples of markets build on information asymmetry. Returning to the example of an insurance market, described by Levitt and Dubner, the situational example offered by the authors unfolded the following way. In the late 1990s the price of term life insurance fell dramatically. This happened because in the spring of 1996
  • 3. 3 became the first website that allowed consumers to compare prices of term life insurance packages offered by insurance companies. The website did not engage in selling packages; however, consumers received better access to information. Since the customers had an opportunity to find the cheapest policy (and since term life insurance policies are standard), the more expensive insurance companies had to lower their prices. Information was so powerful in reducing the prices that consumers paid that Levitt and Dubner continued with the following quote that allows linking the insurance market to the market for lemons: “Information is so powerful that the assumption of information, even if the information does not actually exist, can have a sobering effect”. The authors conclude the cases stating that Internet is a powerful tool for transmitting information from those who have it to those who do not. Thus, the emergence of Internet allowed reducing the information asymmetry in some markets. However, the problem was not exacerbated by the Internet and the possibilities that it offers. One of the reasons is modern abundance of informational resources. Another reason is that it is difficult to find reliable sources that would offer a single estimation of the market.
  • 4. 4 References Akerlof, G.A. (1970) The market for “lemons”: Quality uncertainty and the market mechanism. The Quarterly Journal of Economics, Vol. 84, No. 3 Gladwell, M. (2000) The tipping point: How little things can make a big difference. Little, Brown and Company. Levitt, S.D., Dubner, S.J. (2005) Freakonomics: A rogue economist explains the hidden side of everything. William Morrow.