Market Assumptions - Information Symmetry?

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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Market Assumptions - Are People Rational?

The most basic definition of markets would be a place - physical or otherwise - where people can exchange goods of equivalent value in such a fashion that all parties to the exchange are better off than before the transaction. This is an elastic definition that covers a wide range of markets. We are all familiar with traditional markets. These are places we go to shop and hang around in. These are sometimes classified as business to consumer (B2C) markets. We are also aware of business to business (B2B) markets. Then there are financial markets, commodity markets, internet markets and even virtual markets. These are all types of markets that exist in the real world.

Do the assumptions of perfectly competitive markets hold for them? Examining these assumptions one by one, we are forced to conclude that they largely do not hold true in reality. Studying perfectly competitive markets therefore may make sense at an elementary level when students need to be given a model that can be compared to the real world. When these assumptions are applied to the latter, the wrong conclusions will be drawn and these will result in misguided policy prescriptions.

Take one of the most basic assumptions of economics: rationality. Are humans rational? Economists certainly assume so. Assuming rationality is an extremely tempting simplification to make of a complex reality. After all, each of us has the power of our intelligence to make decisions that will best suit our circumstances given the information on hand. Yet, despite our powerful brains we continue to make important decisions based on emotions.

Emotions are integral parts of our personality. Our rationality is tempered by our emotions. When these two are in balance, it is only then that we make optimal decisions. Unfortunately, often our emotions overrule our rationality. This is most obviously seen in financial markets particularly the stock exchange. If any market is considered to be the closest in characteristics to perfectly competitive markets, then stock exchanges are it. Elaborate models have been built that show that we cannot beat the market and that bubbles and busts cannot happen. But they do. With annoying regularity. And often devastating effect. For example, in 1987 Wall Street crashed by 22.6%. This was the largest single drop ever and was considered to be statistically improbable. In fact its probability was calculated as happening once every 20 billion years. An event so extremely unlikely that it could not happen in any human lifetime. Nor was this a one-off. Wall Street crashed again in 2001 and then once again in 2007. Three statistically improbable events happening within a lifetime! What happened? Economic models based on rationality ignore the elements of greed and fear which play important roles on the stock exchange. When greed rules, the market goes up and a bubble can form. When fear rules, the opposite can happen and the market can crash.

Stock exchanges are not the only places where emotions sway people. Research has shown that people value possessions very highly even at the expense of rational economic calculations. People also fear loss more than they fear gain. They will make a less than optimal choice based entirely on this. So one of the most important assumptions of perfectly competitive markets do not hold in the real world. Yes, people are rational but this rationality is tempered by emotions. Marketers know this and in many markets, they take full advantage of emotional impact. Fear is a great motivator to persuade people into courses of action they would otherwise be reluctant to take. Models that do not take emotions into account simplify reality to an extent that they become useless. Relying on such models is not only pointless but can cause needless suffering and misery.

Next time - an examination of another assumption of perfectly competitive markets.

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What are Markets?

Economists love to talk about markets. Listen to them and it sometimes seems that markets are the panacea to all the ills of humanity. Whatever problems we may be facing, the best solution inevitably is deemed to be a market based solution. So here is a question that quite naturally arises: what are markets? For most people, we think we know. But do we really?

Mention the word market and the image that jumps to mind is a bucolic rural scene filled with small shops selling different things to throngs of happy people buying stuff they need. This image is reinforced for most of us by our memories of Economics 101 where we learn about perfect competition. However, markets like this do not really exist any more. Over time markets have mutated into many different forms each with their own characteristics. This has happened to such an extent that talking about perfect competition is actually a disservice since this reinforces the myth that the conditions that apply to perfectly competitive markets also apply to these other forms of markets.

Perfectly competitive markets only exist if we make a number of assumptions. Some of the most important assumptions underlying these markets are:

• Buyers and sellers have equal information regarding the good or service being sold.
• There is no cost to gathering and assimilating information regarding the good or service being sold.
• No single seller or buyer has the power to affect the functioning of the market.
• There are no entry or exit barriers.
• An efficient legal and regulatory framework exists for enforcing contracts.
• There is a minimum (ideally no) time lag between some new information becoming available and that information being assimilated and acted upon.
• The same forces (primarily supply and demand) act in the same fashion on all commodities.
• All the actors in the market are economically rational.
• Also all actors in the market are able to instantly calculate the amount of "utility" that they will obtain from buying an extra unit of a particular commodity (whether a good or a service).

Needless to say, there are no markets in the real world where such conditions exist. The reason why perfectly competitive markets are studied is that they serve as a good model to understand how an "ideal" market should work; the idea being that lessons learned in a study of this type of market can then be applied to other, more realistic markets. The problem is that most of the important assumptions that underlie perfectly competitive markets are then also implicitly assumed for these other types in more or less their original form. This results in the wrong kind of lessons being drawn. These wrong lessons are transmitted to students, especially business students and eventually percolate to policy makers where they influence policies that can result in actual harm as we have recently seen.

What are these other kinds of markets? To what extent the assumptions stated above hold in these other types? What are the actual characteristics of these other types? These are some of the questions regarding markets that I will be exploring in subsequent pots.

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Innovation

The private sector is touted as being a font of innovation. The government is derided as being ossified, a lumbering dinosaur unable to comprehend the nimble private sector. This is now taken as being a self evident truth. Which is why it is fair to ask whether this assessment can be considered true or false or perhaps partly true.

First why is innovation important? Innovation introduces new tools, methods and processes. Innovation allows us new ways of communication and new methods of consumption. The process of industrialization has placed a premium on innovation. As consumers, we have become attuned to learning new methods of consumption and production. But where does innovation come from?

The accepted answer is the private sector. If we examine this claim more closely, it becomes evident fairly quickly this is a lazy assertion. As always, the reality is more varied and interesting. Innovation does not occur in a vacuum. It requires a context to operate in. Much of that context is provided for by governments. Consider markets. Unlike what a lot of people think, markets need some essential physical and legal infrastructure to operate in. Only the simplest of markets can operate in the absence of these. Who is best positioned to provide the necessary support? Governments. Another area where governments become important for innovation is education. If the process of innovation is to become a regular part of the economy, we need a minimum mass of educated people to support it. Public education is a service that the private sector by itself will not provide on a sufficiently large scale. To fill in the gap, governments need to step in.

By its very nature, the private sector's primary focus is on the bottom line. As such, nearly all companies tend to have a short term, commercial outlook. A particular process or gadget or widget or whatever is evaluated in terms of returns. As such, the private sector is predisposed towards applied science. Basic science is being done by relatively few companies. But advances in basic science eventually lead to commercial applications. In cases where discoveries are made in applied science, these need to be backed up by some theoretical framework before full advantage can be taken of them and further development is done. Again it is primarily governments that provide much of basic science. Even in applications, there have been many commercial spinoffs of government science and government innovation. The Internet is just one of many technologies developed because of government.

To say that government has no positive role to play in promoting innovation is simply wrong. The market system is very efficient but a big flaw in it is that it is by its nature short term and generally not reliable in introducing new techniques and technologies. For that, a much longer view is required. However this does not mean that all such development can be handed over to governments. While governments often excel in basic research and in long term applied research, they frequently fail to commercialize their discoveries. This is not necessarily because government employees are idiots or evil. Usually its just that their training and experience is non-commercial. They simply do not think in a market minded fashion. For commercializing promising innovations, we often need the private sector. Innovation is the life blood of a modern economy but to make it work both the private sector and the government sector are needed.

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The Purpose of Economic Growth

An economy is meant to serve human wants. To that end it seeks to provide the appropriate mix of goods and services. Wants in turn are manifestations of more basic needs. They are a means to an end. The means can change but the wants remain the same. Economic growth arises from a number of factors. Primarily, economic growth is a measure of consumption. Greater consumption leads to greater economic growth. Growth also comes from innovation. New products and services are different methods of servicing needs which in turn create new markets.

The main concern of people lies in economic growth. Faster economic growth is good. Slower is bad. In a way this makes sense. The economy has to grow as fast as population growth in order to provide young people with the necessary jobs that they will need as they enter the work force. That at least is the theory.  However a single minded focus on economic growth essentially ignores the issue of the type of economic growth. We can have (sometimes strong) economic growth without a necessary increase in job opportunities. An emphasis on encouraging capital intensive industries will lead to economic growth but will such industries provide wide scale job opportunities? Promoting service industries will again lead to economic growth but what kind of jobs will be generated? High income? Low income? What about prospects for advancement? Also consider that focusing solely on economic growth means that we are looking at the existing mix of goods and services and the companies that provide the same. It ignores new kinds of goods and services that may develop in the future and become economically important. For example, social media as an economic activity essentially did not exist a decade ago. Today they are multi-billion dollar businesses.

Then there is the question of distributing the fruits of economic growth. In India, the BJP government oversaw 5 years of strong economic growth. Their election slogan highlighted this and emphasized the future of "Shining India". Yet they were thrown out of office. Why? The fruits of economic growth were confined to a relatively narrow segment of the Indian population. A large majority saw their lives and well being worsening in the same period. This was a case of strong but blind economic growth. Part of the roots of the recent Arab uprising in the Middle East lies in economic growth which did not trickle down. Most people assume that strong economic growth alone will result in a general improvement in living standards due to a trickle down effect. But the empirical evidence does not support this argument. Most if not all the gains of economic growth are captured by a relatively small class of people who generally speaking are not interested in much trickling down. In country after country, government intervention proved necessary in order to ensure a more equitable distribution of the benefits of economic growth.

I believe that the purpose of economic growth is not in growth by itself. Economic growth is a means to an end. The end is (or should be) minimizing opportunity inequalities. An important component of this is reducing income inequalities. Poverty not only forces people to scramble to put food on the table and a roof over the head, it also prevents people from realizing their potential. That in turn lowers long term economic growth. High levels of poverty literally act as a brake on economic growth as it limits the opportunities available. It should also be noted that very high income levels often also inhibit people from realizing their potential. This is a reverse effect of a high poverty level as very high income levels lead to a satisfaction with the status quo and the sheer number of opportunities available can have a paralyzing effect.

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Are Corporations Necessary?

Division of labor results in specialization. This was clearly established by Adam Smith more than 200 years ago and has been a central tenet of the modern capitalist economic system. We are all specialists. We depend on others for most of the goods and services that we need. For over a 150 years now, corporations have been the primary mechanism by which we have had access to these. Corporations made sense in the past. By pooling together large sums of money and bringing together people working towards a common purpose, corporations could lower the cost of providing us with what we (think we) need. Changes resulting from industrialization helped this process along. National markets became possible and cost effective to serve. International trade progressively became easier as international linkages increased and strengthened and the cost of transportation and communication steadily fell. Firms could become larger and larger in size and thus service their customers with ever greater cost effectiveness.

However, a funny thing has happened. The same factors which helped spur the rise of corporations kept developing and today increasingly favor alternative forms of business association. Transportation and communication links steadily strengthened, became cheaper and more importantly became more personal. National markets were woven more tightly together as internal trade barriers were eliminated. WTO was envisioned as a means of lowering barriers for corporations. It has had the effect of also doing the same for looser associations and individuals.

However, it is still difficult to answer whether corporations can be done away with entirely. It is now certainly possible to for smaller firms to compete successfully against larger ones in many areas of the economy. Many but not all. In some areas (like petrochemicals) size definitely matters and here larger corporations have a definite advantage. Even in these areas, there are niches where further development is possible and smaller, looser organizations are often better equipped to tackle such areas. Certainly, corporations as they have evolved have imposed liabilities on societies and individuals which are only now becoming apparent. But if corporations are to be done away with, what can replace them. To that, there is no easy answer.

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Why Corporations?

In the current series of posts regarding corporations, I have asked the question do we need corporations? In exploring this question, I then looked why the need for corporations arose in the first place. Related to this is the question of what advantages and disadvantages accrue from having corporations.

Consider two things. Most products and services today require a complex interplay of multiple factors. Corporations are also essentially large groupings of people come together for a common purpose. So in order to bring a product or service to market various tasks need to be performed. In the past, the cost of doing those tasks internally was lower than having them done from the outside. This was a major advantage to forming a corporation. However, while the costs are lower, nevertheless they are present. Also, accounting systems do not capture all the costs of internal transactions. Often, the costs that are not quantized are inherently difficult (and in the past were almost certainly impossible) to do so. So corporations incur costs when going about their business. Some of those costs are quantified by accounting systems. Others are at best estimated and still others are ignored altogether.

Globalization has greatly increased the complexity of doing business. Advances in transportation and communication technologies and a concomitant reduction in the cost of the same has resulted in long, complex supply chains that are nevertheless able to supply technically advanced products at ever reducing real costs. Corporations have taken full advantage of these trends. However these same trends have also lessened the traditional advantages of corporations. If a particular product can be manufactured overseas, what prevents it from being designed overseas as well? The question then becomes can we do away with corporations altogether?

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