Perfect Information
Perfect information is a condition in which all economic agents know everything relevant to their decisions, including the characteristics of goods and services, the actions of other agents, and the state of the world. It is a standard assumption in the benchmark models of competitive markets and general equilibrium, and deviations from it are a source of market failure.
The Assumption in Economic Models
In the benchmark model of perfect competition, buyers and sellers are assumed to have complete information about prices, quality, and the availability of goods. This assumption ensures that the law of one price holds, that goods trade at a single price, and that competition allocates resources efficiently.
In general equilibrium, agents are assumed to know the prices and the payoffs of all securities, and markets are assumed to be complete. Perfect information, together with complete markets, is a condition for the welfare theorems to hold.
Imperfect and Asymmetric Information
In practice, information is imperfect and often asymmetric, with one party knowing more than another. Asymmetric information can lead to adverse selection, in which the party with less information is unable to distinguish good from bad, and moral hazard, in which the party with less information cannot observe the actions of the other.
These problems can cause markets to fail or to unravel. The market for used cars, in which sellers know more about quality than buyers, may be subject to adverse selection, driving good cars out of the market. Insurance markets may suffer from adverse selection and moral hazard, leading to inefficiency and, in extreme cases, market breakdown.
Mechanisms to Address Information Problems
A range of mechanisms responds to information problems. Signalling allows the informed party to convey information credibly, as when firms use warranties or education as signals of quality. Screening allows the uninformed party to induce the informed party to reveal information, as when insurers offer menus of contracts.
Reputation and certification can sustain quality where information is imperfect, and intermediaries can specialise in gathering and verifying information. Regulation, including disclosure requirements and product standards, addresses information problems by mandating the provision of information or by setting minimum standards.
Implications
The analysis of information is central to the economics of insurance, finance, labour markets, and many other fields. It explains the design of contracts, the structure of markets, and the role of institutions, and it informs the design of regulation and policy.
The contrast between the perfect information benchmark and the reality of imperfect information clarifies why markets may fail and why institutions exist to address informational problems. It also highlights the trade-offs involved in designing mechanisms that elicit information and align incentives.
Adverse Selection
Adverse selection arises when one party in a transaction has information about quality or risk that the other lacks. In insurance, individuals with higher risk are more likely to purchase coverage, raising the average risk of the insured pool. In credit markets, borrowers with riskier projects are more likely to seek loans, raising default rates.
Adverse selection can cause markets to unravel. As insurers raise premiums to cover higher average risk, the safest individuals drop out, raising average risk further, and the process can continue until the market fails. Mechanisms to address adverse selection include risk classification, mandatory participation, and the design of contracts that induce self-selection.
Moral Hazard
Moral hazard arises when one party's actions are unobserved by the other, so that the party cannot be held fully accountable for the consequences. In insurance, the insured may take less care once covered. In finance, institutions may take excessive risks if they expect to be rescued.
Moral hazard can be addressed through deductibles, copayments, monitoring, and regulation, though each involves trade-offs. Excessive cost sharing may reduce desirable risk pooling, while excessive monitoring may be costly or intrusive. The design of these mechanisms is central to the analysis of insurance, finance, and the public sector.
Signalling and Screening
Signalling and screening are responses to asymmetric information. Signalling allows the informed party to convey information credibly through actions that would be too costly for the less informed to imitate. Education can serve as a signal of ability, and warranties can signal quality.
Screening allows the uninformed party to induce the informed party to reveal information through the design of contracts. Insurance companies may offer menus of deductibles and premiums, inducing different risk types to select different contracts and thereby revealing their type. The design of screening contracts is a central problem in the economics of information.
The Benchmark and Its Departures
The perfect information benchmark clarifies the role of information in markets. Where information is perfect and symmetric, the conditions for efficiency are more likely to hold. Where information is imperfect or asymmetric, markets may fail, and institutions may emerge to mitigate the problems.
The analysis of information has enriched the understanding of insurance, finance, labour markets, and many other areas. It has also informed the design of regulation, including disclosure requirements, prudential standards, and consumer protection, and it continues to be a central area of research in economics.