2.2 Imperfect information

Define imperfect information

Where information is missing so an informed decision can not be made

What is assumed about information in traditional economic theory?

Traditional economic theory assumes that if individuals possess perfect information, they will make decisions that maximise their welfare.

Where do 'wrong decisions' arise from?

When attempting to maximise total utility, more often than not consumers possess imperfect information. As a result, they make 'wrong' decisions.

Example of a 'wrong decision'

Student may spend £100 for a concert ticket believing she will enjoy the entertainment. However, she may come out of the stadium believing she had wasted her money and would be better off if she had spent the £100 elsewhere. This is an example of a 'wrong choice' but it was also a rational choice as she believed in advance that the concert would be good

Define asymmetric information

When one party to a market transaction possesses less information relevant to the exchange than the other

Example of asymmetric information

A car dealer might know about a fault that a consumer is unaware of

What is adverse selection?

One of the ways in which asymmetric information can manifest itself is through the process known as adverse selection, which is a feature of many market transactions.

For example, in the sale and purchase of second hand computers, the seller of the good knows more about the computers defects than a potential purchaser. However, to avoid paying too high a price for an inferior product which has lots of defects, potential purchasers often offer lower prices on all second hand computers, regardless of the fact some of the computers are good