Let’s start with a defining statement; what we don’t know can hurt us. Economists study how we get information and how we use such information. They also study how we make decisions when we have incomplete information. There are many scenarios when rational individuals are forced to make decisions with incomplete information, or when one party knows more than the other.
Consider a firm interviewing two recent Oxford graduates for a job, both are equally qualified and the only difference is that one is male and the other female. Rationally the firm, considering it is profit maximizing, would hire the man. The firm has no prior information about the family planning of the candidates, but can infer that women will bear the majority of the child bearing duties. Both candidates are likely to start a family in the near future, but only the female will take maternity leave; and more importantly may not return to work after having the child, imposing a cost on the firm.
However none of this is certain, the man might dream of staying at home and taking care of his 3 kids; and equally the female might have decided not to have children. But these aren’t the likely scenarios. The female candidate is still at a disadvantage. This isn’t fair but the firm’s logic makes sense, it is rational to discriminate. But the whole idea of discrimination is that it’s usually irrational. A patient, who refuses to see a black doctor purely because he’s black, is stupid, and so are firms who pass up employing well skilled foreigners just to employ less qualified white people.
From an information point of view, there are many insights to this problem. Firms aren’t the only villains, when a women decided to take paid maternity leave and then not come back to work, she imposes a cost on the company. More importantly, they impose a cost on other women as firms are more likely to discriminate against young women. Of course this can easily be fixed, make the maternity package refundable, meaning you can only keep it if you come back to work.
When the asymmetry of information becomes too large, whole markets can break down. The Market for Lemons is a term coined by a Nobel laureate, George Akerlof. He used the example of second-hand car markets to make his main point. The seller of the car obviously knows more about the car than the buyer. Using this idea, used-car buyers anticipate hidden problems because car owners are less likely to sell their car if they are happy with their vehicle.
The buyers demand a discount because they anticipate a problem, but once discounts are built into the market, owners of high-quality cars are less likely to sell them. This idea of Market of Lemons can also be used in healthcare, where the doctor has more information about your current life than you do. This asymmetry of information creates a massive problem, especially in America where healthcare is privatized. The patient who doesn’t pay the bill, demands as much care as possible; the insurance company maximizes profits by paying for as little care as possible; and it is very expensive for both the firm and patient to prove the right course of treatment.
But things change when you look at long term health; you know more about your long-term health than insurance companies do. You know if you lead a healthy lifestyle, whether or not you smoke; and whether or not you exercise regularly. This information advantage can wreak havoc in the health insurance market. Insurance companies calculate the average health cost for a 50 year man let’s say, and come to the figure of $1000 a year, so they charge $1100 in order to make profit. This $1100 figure is very bad deal for the healthiest 50 year old, but a brilliant deal for 50 year old smoker with a family history of heart disease. Therefore the healthiest guys are likely to opt out, and therefore the firm revaluates the market and now charges $1300.
At this price the next healthiest guys are likely to opt out, and once again the unhealthiest males will happily comply. This carries on until the market inevitably fails. Obviously this doesn’t happen as insurance companies sell their packages in large numbers to other firms who sign a contract to cover their employees.
This begs the question, how much information is too much information? With one strand of your hair or a swab of your saliva, it is possible to determine what diseases you have and what diseases you are likely to develop later on in your life. And if this genetic information is passed on to insurance firms then it means it becomes near impossible for those who need cover the most, to get it. The people who need health insurance the most are those who are least likely to get it.
Similarly, if companies are forbidden from gathering such information, they will be crushed by adverse selection. Individuals likely to get sick will load up on generous policies.
All of this concludes to the point that economic decisions are based around information, and too little information can be as devastating as too much information. Information is the key to all our decisions.