Turned up to eleven: Fair and Balanced

Wednesday, April 10, 2002

I am going to write a couple of longer posts this week (I hope!), one about something I know a bit about (predominance of "left-handed" amino acids in proteins), and one about economics! The econ comes first (since I know nothing about it, I don't feel any pressing need to do research!)

Many people seem to cast economic debate on the following linear scale; either you are for free markets, or you are for price controls and regulation. At first glance, this seems perfectly reasonable, and these two opposing viewpoints seem to be the options available.

As an aside, this always reminds me of the climactic scene in The Good, The Bad, and The Ugly, "There are two types of men in this world-those with loaded guns, and those who dig...now, dig!" It also reminds me of the old joke, "There are two types of people in the world, those who divide people into two types, and those who don't!" (But I digress...)

An observation about the "dismal science"-Economics is psychology writ large. What do I mean? Well, Econ is often portrayed as a scientific analysis of broad patterns of money flow and production of goods. That is all well and good, and certainly true, but when you get down to it, what economists are really studying is how people behave, i.e. when and why they choose to buy things, work, etc. So, economics is a form of aggregative psychology, where economists try to predict the aggregated behavior of everyone, as opposed to psychologists, who try to understand the behavior of individuals (although they may derive common patterns that apply to many people, or everyone). IMHO, the point of all this aggregation is the hope that individual variation (whims, if you will) will fall out when the behavior is averaged over the population, and patterns will emerge. This has held true, to a certain extent, and economics research has certainly been productive, but fundamental questions, of course, remain. It seems to me that a very fundamental one, which has been partially answered in recent years, is the question of overall resource allocation, and the balance between centralized (government) control and the "invisible hand."

Recently, (last year, actually) the Nobel Prize in Economics was given to three economists who studied market dynamics with "asymmetric information." Here is the gist of the research by Akerlof, Spence, and Stiglitz, using the example of "lemon" used cars. The sellers of used cars, in general, have more information about the cars' states than the buyers. Because of this asymmetry, buyers have a different metric to use when they buy a car from a used car dealer; instead of assuming that the car is in good shape, and evaluating it based on known standards (Kelly Blue Book value, for example), the buyer may assume that they are going to get screwed, and therefore have more incentive to distrust the dealer. The dealer, in turn, observing that he is not trusted, has little incentive to be trustworthy. This all seems like common sense, but the Laureates insight, using this model, was to predict how this asymmetry of information would affect the allocation of resources within this market. They also showed that this analysis could be extended to many other markets.

I would like to take this hypothesis one step further. Here is my (possibly bold, possibly not) hypothesis;

All Markets Are Asymmetric

Simply put, in every transaction, there is a difference in the quality and quantity of information possessed by buyer and seller. This difference may be small, in which case the "efficient markets" model will hold. There will be some value (lets call it delta) for which when the asymmetry of information {abs. value I(b)-I(s)} will be a "tipping point", and markets in which this asymmetry is greater than delta will be inefficient. The purpose of regulation of these markets, then, will be to make them efficient, and two methods are immediately apparent. One method would restrict actions, to ensure that neither side could take advantage of the extra information it possessed. The other, and to my mind, much better option, would be to mandate full disclosure i.e. ensure that both sides have access to full and complete information about a given transaction. If this were the case, any advantage gained or lost is the result of negotiation skill, rather than asymmetric information.

There is another market asymmetry, however, that I think is also important, and that is elasticity. It seems to me (and I am certainly no expert) that a lot of market analysis is based on markets in which neither side is particularly dependent on a given transaction. In the example above, a used car dealer is not forced to sell this car to this customer, and the customer is similarly free to go elsewhere. A person with cancer, however, is not able to pick and choose caregivers or insurers, while the insurer has a strong incentive to deny coverage when possible (this is partially countered by the legal recourse, and potential bad publicity). This results in a marketplace that does not efficiently allocate resources (i.e. people don't get the appropriate level of care or coverage, and don't pay the appropriate amount for it). Some people pay far too much for health care, and others far too little. Conversely, a country that only produces one commodity (say, oil) is even more dependent on that commodities market than countries that depend on oil for energy. That is why the OPEC countries banded together in the first place, to everyone's detriment. If they had diversified their economies instead of protecting the price of "black gold", they would probably be in better shape than they are (and so would we).

Let me expand a bit on that last point (it just occured to me as I wrote). The OPEC nations are highly dependent on the outflow of oil, and the inflow of capital, to maintain their economies. If OPEC did not exist, would this still be the case? I think not. These nations would have been long ago forced to diversify their economies, to find other resources to exploit, to create jobs that utilize diverse intellectual and physical skills. Incidentally, the monarchies and dictatorships (kleptocracies?) that dominate in these countries would probably have been overthrown long ago. The asymmetric market strikes again?

These two examples are extremes, of course, but I think it is fair to say that asymmetries of information and elasticity of supply and demand are at the core of all market malfunctions, and exist to some degree in every real market. Can anyone out there come up with a counter example? I would love to hear it. Keep in mind that I am not saying that the asymmetry is always large, or always important, just that it exists, and that a comprehensive economic theory must account for it.