A basic tenet of perfectly competitive markets and one that is assumed to hold for other types of markets is that of information symmetry. This is the assumption that buyers and sellers in a particular market have the same amount and quality of information regarding the transaction under process. A secondary assumption (which is still nonetheless very important in its own right) is that even if there is information asymmetry, it will exist for a very short while and the cost of acquiring the required information is low or non-existent.
Do these assumptions hold in the real world? The short answer is no. I cannot think of any market where these assumptions hold true. In any market environment, there is some form of information asymmetry. Almost always the seller has greater information regarding the product(s) on offer. What is more, the cost of acquiring information is usually large. This cost is not just monetary. There is the cost of the time required and the opportunity cost of not being able to do something else while the search for information goes on.
This particular fallacy is thought to hold particularly well for financial markets especially the stock exchanges. The efficient market hypothesis holds that any information relevant to the stock in question will immediately be reflected in the price of the stock. The reason for this being that given the large number of people playing the market, someone somewhere will analyze and act upon the new information. This is a fundamental reason why some economists insist that stock markets are efficient. However, others have pointed out a contradiction at the heart of this idea. If any new information will immediately be acted upon by someone somewhere, then there is no point in seeking out this information. This will hold true for all players. Therefore no one will have an incentive to seek out new information that may be relevant and so the price of the stock will not reflect all available information. The financial services industry has also evolved new financial products nearly all of which have one primary feature: they literally require a rocket science degree in order to understand them. The sheer complexity of these products also means that the buyer (and frequently the seller too) does not understand the basic product. Theoretically this poses no problem since such products are supposed to be sold to sophisticated institutional investors. However as we have already seen, such investors are actually not very sophisticated. The result has been that all sorts of buyers have been exposed to a high level of risk. Is this efficient? No.
Information asymmetry can be seen in many other markets. Take as an example, the market for lawyers. Why are legal fees so high? The reason is that legal documents are couched in obscure jargon which is almost impenetrable to a lay person. Ordinary people simply do not have the information required to be able to bring down legal fees. Infact virtually all professional services markets are able to command high prices because of information asymmetry. Almost all secondary markets suffer from the same malady. Why do previously owned cars sell at a steep discount? Because the buyer does not have the same amount and kind of information regarding the condition of the car that the seller has. Fear of buying a lemon brings down prices for all sellers. Assuming markets have information symmetry is not only wrong, it is actually foolish. A model based wrong assumptions will inevitably lead to wrong conclusions and wrong policy decisions. And then everyone wonders what went wrong?
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